The stock-picking debate that won’t die

Good morning. I’m Katie, filling in for Rob while he’s drinking piña coladas on a yacht or whatever he’s doing. I’m in desperate need of some sea and sun too. A (very kind and well-meaning) colleague just told me I look “tired”, and he’s not wrong. Send me a nice email to strengthen my sense of humour before my summer vacation: katie.martin@ft.com

Actively weird

Look, it’s summer, the markets are quiet, and when the last humans are roaming the Earth, traversing dystopian hellscapes in search of food, they’ll still manage to argue about the relative merits and demerits of passive investing. So I have no qualms about delving into the topic again, though Rob wrote about it Only very recently.

Market pundits (and if you’re reading this newsletter, you must be one of them, at some level) are all too familiar with the popular refrain that all those big, bad interest rate hikes are bound to hurt weak, poorly run companies more than strong, nimble ones. This dispersion means it’s a good time for stock pickers rather than index huggers. As I wrote last October, the bet was that Active investing is back.

How has this worked? A little bit of Control your enthusiasm Maybe music is the way to go here.

In Europe, the situation has been “really very good,” as Helen Jewell, head of European fundamental equity investments at BlackRock, told me in a recent talk. The performance of those kinds of portfolios has been “strong,” she said, though the exact degree of strength is a bit of a mystery: It’s not something the firm can disclose. Some areas of outperformance stand out. For example, take the roughly 20 percent rally in European banks earlier this year. The momentum from that has waned a bit now, but, heck, that’s roughly equal to the gains in Apple, and double the gains in Europe’s Stoxx 600 index overall.

In the US, however, the strategy is not as good. There, the intense market concentration in terms of size and profitability means that, as Jewell said, it is essentially impossible to outperform the index unless you are overweight one of the giant tech stocks – “and how active is that?” he asks.

More broadly, much of the dispersion that Jewell and others predicted a few months ago simply didn’t materialize on the scale she expected, and for stock pickers, “the U.S. is a tougher place to be.”

But why? Why have growth stocks been so resilient to the massive rise in interest rates? Loose fiscal and financial conditions are high on the list of possible explanations, and something may have changed in corporate behavior, too. But perhaps it’s investors who are acting differently, or indeed perhaps we have a new type of investor dominating the market, probably the passive index-tracking group. Jewell says she’s not sure and would like to know. Email me if you think you have the answer.

And another thing . . .

A couple of other interesting details on this topic have recently come onto my radar.

One, which I mentioned In a column The other week, comes from a report entitled “Ponzi Funds” which studies what happens to stocks inside fad and demand funds. The short answer is that they soar in “self-inflating feedback loops” until, inevitably, the fund falls out of favor with the market.

It’s an interesting analysis, read it. But one fund manager told me it made her wonder whether a large number of people in her profession are wasting their time. What if the entire S&P 500 worked the same way? What if the index’s performance was based on flows into passive funds and had nothing to do with corporate fundamentals? What if the vast majority of analysis on individual stocks was meaningless? It’s enough to make you wonder what you’re doing with your life.

Another issue is how holders of passive index-tracking funds are systematically losing returns.

In A studyInvestment firm Dimensional Fund Advisors analyzes the process by which indexes add new members (usually because, for example, a company becomes large enough to qualify) or expel existing members because they have shrunk or no longer fit into a particular family of stocks due to strategic changes.

A wealth of academic research has already shown fairly compelling evidence of what one might instinctively believe to be true: stocks rise when they are added to a large, popular index, and fall when they are removed from the index. What is less obvious is that this effect disappears later, and later.

“The average excess return on added/deleted securities is 4% over the 20 trading days prior to reconstitution, with a reversal of -5.7% in the following month,” says the Dimensional study.

The problem is that much of the rise or fall is concentrated in a very small window of time, often just a few seconds at the end of the trading day before a stock is added or removed, because index trackers try to match closing prices. The upshot of all this is that index funds, which are required to buy and sell stocks according to the index providers’ schedules to avoid any slippage relative to the benchmark, systematically buy at prices that are too high and sell at prices that are too low.

Index providers have tried to smooth out these effects, for example by announcing future changes well in advance and spreading additions and deletions out over several days. But Dimensional’s analysis suggests the effect has not gone away. The result is a constant whine as index trackers miss out on potential returns.

“An index-tracking approach typically lacks flexibility, which can leave returns on the table,” Dimensional wrote. If they simply waited a few hours after a rebalance to buy or sell stocks affected by these rebalances — typically waiting until the next trading day — they could squeeze out some useful extra chunks of returns.

Now, that’s a pain, and possibly expensive. In the end, it may be that passive trackers are so cheap that they outweigh any of these potential drawbacks. But all of this is a useful reminder of several things: Passive investing is not, first and foremost, a neutral decision. Indexes are not natural phenomena: they are created and modified over time by humans making human decisions, often with a clear objective. Great discretionIt’s worth considering whether it really makes sense to link your investment results to those processes. Second, some of the costs inherent in index tracking are hard to see. And third, passive index trackers are now so popular that they make markets do things that are strange to everyone else.

A good read

This (admittedly quite random) story He has it all: a dismissed vicar, ladies of the night and a lion.