Don't quit the market ... just quit hugging the index

PORTFOLIO POINT: Fund managers tracking the index are locked into a faulty structure. The index should only contain the best-performing stocks, not the biggest.

Rather than reporting on companies that I think are good, bad or ugly, this is a story of far more enduring importance to investors.

So let me start with an observation: investors are leaving the stockmarket in droves.

This is reflected in massive outflows for many fund managers – the industry lost $9 billion to outflows this year, forcing some like Wallara and Constellation to close their doors. Others, like Platinum, saw funds under management decline from $17.8 billion at the start of the year to $14.9 billion, with outflows representing $1.7 billion of the decline.

Brokers too are succumbing to the pressure. The 30% reduction in natural volumes through dark pools and high frequency trading is forcing brokers to respond in a variety of ways. Some who have been around for more than a century such as Bailleus and F.W.Holst are consolidating – merging to reduce duplication. Others are cutting staff en masse or simply hoping for a return to the good old days.

But the good old days may be a distant memory as the proportion of “dissavers” (natural stock sellers) overwhelm the number of investors who are of accumulation age.

Investors generally are simply sick and tired of lousy returns and heightened volatility as shown by Figure 1.

Click to enlarge

Even the institutional investors are jack of the poor returns. AustralianSuper head of equities, Innes McKeand, was recently quoted as saying the group is “in the process of putting a platform in place” to manage in-house a part of $15 billion it has allocated to Australian equities. This will put even more pressure on fund managers who have built businesses that rely on a few large clients and pressure broker margins as the larger AustralianSuper seeks volume discounts on its deals.

One response to the poor returns and higher volatility has been to leave equities altogether and move towards income securities and annuities. Challenger’s advertising – telling boomer investors what they want to hear; that they’re not young enough to be able to afford to wait for a stockmarket recovery, has been very effective. The campaign makes leaving the stockmarket look like a mature decision rather than a mad panic to protect what is left and jump into the latest fad.

The ads have helped Challenger become one of Australia’s largest fund managers, enjoying six halves of strong fund inflows to push funds under management to $31 billion.

My personal view is that financial services industry participants, and particularly brokers, fund managers, asset consultants and rating houses have brought this upon themselves, and the solution is a complete and total rethink about what works in the stockmarket.

The solution for investors retiring and needing funding for another 30 years of spending, lifestyle and health care is not to leave.

Figure 1 simultaneously reveals why the stockmarket has become unpopular and why large institutional funds are shifting to exchange-traded funds and index funds.

It’s easy to put Figure 1 in front of an investor and show them that they should not be in stocks if they want to sleep well at night and avoid the risk of serious capital impairment.

But the reason for the poor returns of the index and those of investors who follow its path – ensuring they minimise their ‘tracking error’ – is not because of China, a recession or Greece. The reason is far simpler than that. It is the index itself that is the problem. More about that in a moment.

Rating houses have correctly rated fund managers on their ability. They provide an essential service for investors to gauge the relative merits of those that seek to be stewards of the life savings of their customers. Unfortunately, one of the measures of this ‘ability’ is tracking error. Tracking error is a measure of how far the fund manager strays from the index – yes, the very same ‘index’ that has the problem I will discuss momentarily. The best fund managers are supposedly those who have the ability to keep their tracking error within defined ranges.

Investors however care only about ‘down errors’, not tracking errors. They want to make money and protect their capital. Rating a manager more highly for their ability to stay within a defined band around an index that itself has no ability or desire to preserve a retiree’s savings is a huge flaw and another reason investors are fed up and leaving.

Further, asset consultants are the parties that are asked about whether to be in stocks or in cash even though the fund managers are at the coal face. The customers have fallen for the idea that when one surrounds themselves with economists, strategists and studies of correlations and volatility – mere euphemisms for nothing more than historical price action, the ability to forecast which asset class is going to outperform is improved. The result is that fund managers are allocated capital ‘from above’ and required to be fully-invested even if they don’t like the stocks they are forced to buy or the price they are forced to pay.

There are any number of fund managers who would have loved to have been in cash – like us – over the last 20 months. They aren’t allowed. If they want to keep their funds under management, their revenues and their kids in the schools at which all their friends attend, they toe the line and stay fully invested, even if they are 100% convinced that a ‘dislocation’ of epic proportions is in the offing.

A desire to reduce business risk and qualify for professional indemnity insurance will ensure that any change to the status quo will be like turning the Titanic. Passing the responsibility of decision making to someone else spreads the risk so no individual party is to blame when things go wrong or returns don’t meet expectations. And fund managers, irrespective of their preferences, comply because complying is the path of least resistance to ensuring food on the table.

But an exodus is in train and dissatisfaction reflected in the examples given earlier. And the industry has brought the exodus upon itself. Only a significant shift in thinking will ensure that investors get the best from the stockmarket, which includes maintaining purchasing power over a decade or two – something bonds, annuities and cash cannot hope to achieve at current rates.

Using the index as a measure of stockmarket returns is the first thing that must change. The stockmarket has actually been a very good place to invest if you avoided the companies that have damaged returns. That is self evident, but the point is that the companies to avoid are relatively easy to spot.

The index upon which all arguments are mounted for and against investing in shares is not invested in the very best stocks. It is invested in the very big ones. And the very big ones are not necessarily the best.

Companies like NAB, Wesfarmers, Leighton, Lend Lease, Telstra, Boral, Transpacific, BHP and Rio have added little or no intrinsic value for several, if not many, years. And if you believe, as Benjamin Graham did, that in the long run the market is a weighing machine, then you know share prices follow a sensibly calculated estimate of intrinsic value.

Provided that intrinsic value is based on business performance, then any business with poor or mixed business performance will see its share price produce only modest long-term returns at best. It should come as no surprise that BHP trades around $30 – that has been my estimate of BHP’s intrinsic value for a long time.

Figure 2 on Telstra also illustrates what I am referring to. Little or no increase in intrinsic value.

Click to enlarge

More importantly, that index I have been referring to is made up of these companies and they carry a heavy weighting and influence over its direction.

The secret to safe returns for investors and the secret to investors returning to shares is simple. Put together a portfolio of businesses, not a portfolio of stocks. Ensure the portfolio of businesses is populated by the best-quality companies and those whose intrinsic value is rising, not merely plodding along sideways.

Next, give fund managers the ability to decide whether to be in cash or shares. And finally, ensure new indices are created that are based on quality rather than size. Fund managers may never grow to be as big again, but returns to investors are not determined by the size of a fund.

Do these things and investors will return. To preserve purchasing power, they must return. Genuine long-term returns will eventuate and investors will return for the genuinely long term.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.