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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Tuesday, April 4, 2017

On the Epidemic of "Buy Low Cost Index Funds"

We residents of NYC and its environs regularly pay 3x the retail price of a pint of beer to drink it in a bar vs at home. There's nothing complicated with pouring oneself a beer at home so it begs the question: What do we get for this markup?

Bar owners require compensation for their rent and overhead, but they succeed solving problems for clients not themselves. To my mind, bars solve the problem of a scarcity of places where one can legally drink in public and the prohibition against talking at the library. I'm sure there are others as well. This is why we outsource the pour.

Choosing between bars is as easy as knowing the difference between cheap and expensive bars; Yankees / Giants / Rangers / Knicks bars or Mets / Jets / Islanders / Nets bars; hipster bars, Wall Street bars, sports bars, UK pub-type bars, Russian style vodka houses, gay bars, lesbian bars, Irish bars, tourist bars, after work bars (including those that cater to those working night shifts and therefore open at 10AM), etc.

In short, with bars, you pay up, but know what you pay for and it is easy to comparison shop. One thing I can say for certain is that I've never seen anyone standing outside a bar exhorting everyone to "only buy the low cost drinks".

***

This post is about ...

the difficulty to comparison shop between ETF products;

the inability for the majority of people who don't work in finance to know what they're actually paying for when it comes to ETF's / index funds;

and how those people who want as little risk as possible are sold ETF's / index funds as the "low risk / low fee alternative" but actually face wildly overlooked risk that could be potentially disruptive to their savings.

... The assumption that anyone at anytime can buy an index fund and hold it forever as a solution to their savings / investment goals is as crazy as inviting a random person into their house to replace a water heater.

ETF's are a convenient - perhaps too convenient - solution to a most difficult problem of how to find and identify good investment managers. The ETF solution? Don't even bother! I'm a little biased here, but I think hiring an investment mgr can / should be done the same way one finds a doctor, lawyer, accountant, plumber, mechanic, etc. and the effort is a worthwhile alternative - even to the modest saver - to blindly buying and holding ETF's.

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How finsvcs are different and how performance is woefully misunderstood 

Like other industries, there is generally an "information asymmetry" in finsvcs by virtue of the fact that an unknowledgeable client pursues the expertise of a knowledgeable professional, the same as when most people hire an accountant, plumber, doctor, contractor or mechanic, etc.

In most of these cases, an expert is hired to solve a specific problem and so there is match between what is provided and what is experienced. This expert is generally found by word of mouth, referrals, prior experience, marketing, price or convenience.

Also, like other industries - services and otherwise - there are multiple price points for the consumer to consider. And finally, like other industries where competition, low barriers to entry and a mechanized option exist, prices are coming down.

However, finsvcs differs from these other industries in three ways ...

1. In most industries, everyone sort of knows what value is offered at different price points ("leather heated seats" or "a knowledgeable helpful person on the other end of the phone") but not so much in finsvcs.

2. With a plumber or mechanic, accountant or even doctor, the engagement ends when the problem is solved. In finsvcs, the engagement goes on indefinitely.

3. In finsvcs I see a difference between the value the service provider thinks they provide and the value the client thinks they get.

... in all three of these cases, the difference between what is experienced in other industries and what is experienced to the finsvcs consumer generally resolves to "performance".

"Performance" however is woefully misunderstood. I'll get more to this later but suffice to say, since "avg performance after fees" always lags "avg performance excluding fees", we're living in this supposedly rational effort to simply "reduce fees." This has led us to this strange place that's poorly resolved with the oft repeated mantra "just buy low cost index funds."

I agree on the need for fee reduction, but needless to say, I believe the mantra to "just buy low cost index funds" is more of an epidemic than a trend and reflects further efforts by Wall Street to compel ignorance through propaganda while separating people from their money.

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Comparison shopping is easy in the grocery store but hard for ETF investors 

It is perhaps an imperfect analogy but I see investors as grocery shoppers and often vice versa. The investment decision in my opinion is just a super refined version of the same kind of decisions that millions of supermarket shoppers make everyday.

And how do shoppers and investors make decisions? By inspecting the product. Both investors and shoppers are able to make informed decisions on products b/c regulations - "Section 13 or 15(d) of the Securities Exchange Act of 1934" and the 1966 Fair Packaging and Labeling Act - that require accurate and honest labels about the products inside.

I have no doubt that the learning curve to reading labels on SEC documents is a little steeper and longer than the learning curve for supermarket labels and therefore the group that does one is narrower than the group that does the other.

Yet, in both scenarios the consumer who is adept at reading the labels can make an educated decision that justifies their choice and potentially adds value to the experience they seek. It calls to mind the old Syms slogan "An Educated Consumer is our Best Customer".

So what labels are read by the massive number of Americans savers who have entrusted trillions in savings to ETF's and index funds?

In an environment where even the Oracle of Omaha says ...

"Both large and small investors should stick with low-cost index funds."

... what labels can "large and small investors" read to learn about the past and / or potential future performance of the fund? The answer is in the ETF prospectus, and they are light on relevant details.

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The finsvcs industry probably doesn't want better ETF labels or for you to know their valuations

I come from the school of thought that when you buy a stock you become a part owner in the company's future cash flows, and that the stock's performance - over time and when acquired at a reasonable valuation - should approximate the company's cash return on total capital.

So I invest in a company's performance - it's collection of assets + / - mgmts ability to solve the variety of problems faced every day, etc. - with the expectation that over time, and with patience, if I'm right on the company's operating performance, eventually the stock performance will follow. I try to buy a good operating company at an inexpensive price and grow my capital as the company grows.

I am able to do this b/c of information available to me about the company via its "labels" (ie its 10Q's and K's), which, when properly analyzed, can indicate at the very least it's historic performance at generating a cash return on total capital.

Flip to an ETF label - its prospectus - and it seems devoid of information that would seem meaningful under this rubric. All you get are lists of the companies and their weightings.

Now this can be informative, but not along the lines of determining the aggregate present value of future cash flows of the contents of its portfolio.

Informative more along the lines of knowing that ~6% of the Vanguard Social Index funds is wtd to energy / mining companies, which should be meaningful to the investor who owns it in the effort to implement an SRI strategy (whoops!).

It seems to me these prospectuses would be more helpful if they included information on some independent variable like the RoTC of the the stocks in the index and for the entire portfolio, or other information that is essential to stock investors, such as sales growth, cash flows, earnings growth, etc. for each company and in aggregate.

That way investors would at least have a guide of knowing how much they're paying dollarwise for these independent variables. Those variables ultimately define the fundamental performance of the underlying companies.

Unfortunately, the big effort in finsvcs industry right now isn't about better product labeling on the most popular product of all time, but about the "fiduciary rule", which is a fight about whose interests should come first in the customer relationship.

I have a hard time holding these two ideas in my head without getting back to my earlier conviction that the mantra "buy low cost index funds" is an effort by Wall Street to compel ignorance through propaganda while separating people from their money.

Because if they are fighting against putting client interests first, they probably aren't.

***

Explaining ETF's to my kids 

My kids - two boys, 10 & 12 - have started getting interested in investing. I've been trying to figure out how to approach it with them in a constructive way that also dissuades them from pursuing it as a career choice, and I decided we would start simply by picking a few of the 1,000 largest stocks (still) posted daily in the WSJ along with a few index funds.

But what are index funds? My kids heard the phrase but don't know what it means, so we talked about it.

I gave them the analogy of a deck of cards. With a single stock, they can buy one card in the deck, and they would get a cut of / or / pay part of the cost of the kiddie whenever that card was played and won / lost. Which card would they want to own? The Aces, they said.

If everyone wants the Ace, its price goes up, then which card do you want? K, Q, etc. Can't even the lowly Deuce win a hand? etc.

The alternative, I suggested, would be to take a 1/52nd slice of every card in the deck, and create a new card that is equal portion of every card in the deck. That, I said, is like an index fund on the deck.

They said: "But then, if all the cards are used in a hand, don't the winners offset the losers?" And "Not every hand has every card so just a few cards will be played most often" And "The more hands played the more money the casino makes"

I'm starting to realize that even though they barely do a single thing I ask of them, at least they aren't stupid.

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The goal of investing isn't to own ETF's or stocks

The goal of investing is a return on capital in excess of the rate of inflation without bearing the burden of "excessive" risk. I put "excessive" in quotes b/c there are a lot of different kinds of risk and it can mean different things to different people at different times of their lives and depending on their needs.

The benefit of ETF's is that they offer broad exposure to the market at a low cost with the ease - to both the buyer and the producer - of not having to understand (or disclose) what each company in the portfolio is doing. But keep in mind, "broad exposure to the market" isn't a goal in and of itself; the goal is the return on capital, etc ...

ETF's don't promise the return on capital part, they just promise the elimination of single company risk the same way any diversified portfolio does. If you compare an ETF or index fund to any diversified portfolio, one could safely say that ETF's are better and cheaper than alternatives at achieving this low risk return on capital goal, etc. This is an important attribute.

Through this lens, if you think about the problem an ETF solves, then you think about the problem a diversified portfolio solves, and you eventually get to theories on CAPM and the efficient frontier, etc.

And what problem do those theories solve? The problem - essentially - of how to judge and define a good investment mgr. It is - and remains - a ridiculously hard problem to solve. Endowments have a hard time doing it. Institutions have a hard time doing it. It would be nearly impossible for the average person to do it. So, from CAPM, to efficient market hypothesis, and all the way down to ETF's, the theory boils down to, "don't even bother trying".

The point is that ultimately, with ETF's you're just getting a ridiculously inelegant solution to the supremely difficult problem of how one should actually go about identifying good investment managers who can consistently generate a return on capital faster than the rate of inflation, and with limited risk.

And yet ... something is missing here. B/c when 99% of the world thinks about ETF's they're really just thinking about two things: Fees and Performance.

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It should be easier to know what you're paying for

As it currently stands, Fees and Performance (along with some generic title) are essentially the only labels ETF investors look at. In a simplified world narrowed down to just those two things, and where one of them - performance - generally looks the same across asset classes, the mantra to "buy low cost index funds" makes a whole lot more sense.

The trouble with this "two label" solution isn't just the opacity. As an industry we woefully misinterpret performance.

As we know it, performance is the change in the market value in a stock. But the price of a stock isn't information about a company, it's simply information about how "the market" values that company, day to day, quarter to quarter, etc. The "voting machine" at work. Stock price performance ignores the the critical information regarding some underlying independent variable about the operations of the company, like earnings, revenue growth, FCF Return on Total Capital (or something).

If people look at performance to buy funds, and they are only buying funds with good performance, then they are purchasing something that has already increased in price. Whether or not this is a good idea is hard to say - not enough information - but there is no doubt that buying something for the sole reason that it's gone up on in price isn't remotely related to a good capital allocation decision.

Let's say there were a better "standard label" for index funds and frankly for hedge funds and investment managers of all stripes as well. Not just Fees and Performance but information that would enable investors to choose whether they want to pay more or less for that independent variable. This would help them choose between products.

I'm not talking marketing.

I'm talking better labels on the portfolio that enabled shoppers to really compare / contrast products - say the aggregate FCF Return on Total Capital of all the companies in the fund and the valuation multiple on it ($x for every % in RoTC) - and it could be compared to the aggregate and valuation multiple of the benchmark, then customers would know better what they were paying for.

Whatever metric, it would at least incorporate one of the more important attributes of capital allocation, which is price paid for some independent variable.

This could (and ostensibly should) be calculated for any portfolio. With this improved "label", shoppers would have better information to choose b/t products. It would certainly be better than the most bullshit of labels imaginable, the Morningstar "five star rating".

I'm not saying this is a perfect solution. I'm sure if I'd pull back the layers on this idea, there would be multiple methods of gaming the system (and no doubt in this business, someone is always gaming the system), but it is a simple opportunity to add reasonable, fundamental and easy to understand information that would enable consumers have more insight into what they're buying.

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There is plenty of room for a differentiated strategy 

An important question you rarely hear is; "are you willing to accept different performance than the market? It might be better it might be worse, but I assure you it won't be the same." Why bother asking it?

We know for a fully loaded 30 basis points investors can get some undifferentiated market return. This means that anything paid above that - 100bps for a financial adviser or 2% / 20% for a hedge fund - implies that there is some "other service" offered for the incremental costs.

What are those other costs?

Here I am, starting my own investment mgmt business ("the food truck version of a hedge fund"), trying to figure out how to get traction with "folks who look like us" ($50k to $5M to invest), and many of them say, "we'll stick with low cost index funds".

Meanwhile, the larger and more sophisticated investors I know stick with name brand expensive hedge funds. (And what is a brand really but another "authority shaping mechanism").

So I ask myself a whole lot of questions ...

How do I sell?
What's the right target and pace of growth?
How long should it take me to get to $10M, $20M or $50M AUM?
What steps do I need to take to have functional substantive conversations with family offices / endowments?
How long is a sales cycle?
etc
etc

... Conventional wisdom says that performance is a big part of AUM growth but I think the evidence suggests that scale supports AUM gathering at least as much, if not more than, performance. I even venture to observe that scale drives AUM growth while performance chases it away, but that might just sound fancy and mean nothing.

But what justifies fees? This gets back to the unoriginal question above. I think "stewardship of capital" broadly defines the endeavor, which broadly speaking is some combination of ...

don't lose it
grow it
kick out some income
help me make decisions / help take care of it for me
i trust you (and a host of other emotional content around money)

... none of that is worth anything to anyone who isn't willing to accept a differentiated return.

The point of mentioning all this is that it would be so much easier if I could compare and contrast my portfolio with benchmarks, not in terms of "performance" but in terms of maybe price / aggregate RoTC of stocks in the portfolio or price / aggregate revenue growth or / aggregate book value, etc. It would be neat of I could do this (on Interactive Brokers I can't even get real time quotes anymore without paying $1,464 / year).

Everyone says fees is a friction in finance but I think the real friction is the inability to tell critical and meaningful differences b/t products. Meanwhile, instead we're all just told "just buy the lowest cost one" as if we all should just eat spam for dinner.

-- END --

ALL RIGHTS RESERVED. COPYRIGHT LONG CAST ADVISERS.

2 comments:

  1. There's a bit of a cliffhanger here, so I'll bite. What's LC's $x for every % in RoTC vs, say the R2k?

    An enjoyable and informative post. Thanks.

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    Replies
    1. I spent a bit of time trying to figure this out but I gave up. I'll take a stab at it again someday.

      All my recent purchases have low or negative RoTC with the expectation that there will be material improvement in the R portion of the business in the next 12- to 24- months.

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