Thursday, December 1st, 2016
This equity cycle has been characterised by two leading dynamics; 1) the further contraction in average holding periods 2) the proliferation of passive (smart-beta) investing.
For decades the average holding period of equities has been in decline, with the stocks being held for shorter periods than at any time since the 1920’s. According to Ned Davies research, the average at the end of 2015 was just 8.3 months! Whether this is a consequence of greater efficiency in markets and/or evolution of capital markets is open to debate. Perhaps of greater significance is the proliferation of electronic trading and passive investments since the Global Financial Crisis.
Electronic trading has resulted in less stock inventory held by traditional market-makers, which in times of increased volatility can provide a certain element, or cushion, of market liquidity. With this removed and equity markets increasingly short-term focused, one can argue that the risks of another ‘flash crash’ are heightened. Whilst this may be a bit sensational, the key point is that we should be prepared for greater levels of volatility than experienced in, arguably, any previous cycle. According to the New York Stock Exchange, the annualised turnover level has fallen to 61% from at least 95% between 2004 and 2011. On face value this implies that the investors are becoming more patient and holding periods are set to increase. That by all means does not tell the whole story.
Firstly, a significant amount of the total volume is not actually traded on the NYSE, but off exchange through alternative exchanges and platforms. According to an article in the Wall Street Journal; “including trades on all marketplaces, the annual turnover rate in US stocks is running at 307% so far this year, up from 303% in 2014, reckons Ana Avramovic, a director of trading strategy at Credit Suisse in New York. That is down from the peak turnover rate of 481% in 2009, but it amounts to an average holding period of only 17 weeks.” Furthermore, many companies now report quarterly numbers, creating a risk that management get caught in the short-term guidance game. It is worth pointing out that this probably suits sell-side analysts, whose objective is to increase activity and thus commission revenue.
The fall of active management and rise of commoditised passive (smart beta) investing may have given investors a myopic view of the former. There is common assertion that traditional asset management is a dying business and that “stock pickers” cannot outperform their benchmark indices over the longer term, thus unable to justify the fees charged. Smart beta (factor-based) investing has been on the rise for a number of years, not because of some intellectual superiority, but something far more simplistic. It’s disruptive and is cheaper than suffering from buying an expensive so called “closet tracking” fund. This shift has affected everything from how pension funds manage retirement money to how shareholders vote. The ebbs and flows of the equity market are arguably becoming impacted by smart-beta investing. The number of S&P 500 companies that ETFs and passive mutual funds own at least 10% has skyrocketed to 92% of the index.
This apparent myopic view of active management fails to recognise that equity markets have moved up and down in unison no matter what the catalyst. Since quantitative easing has been turned off in the US and the UK, we are arguably moving from a passive to active risk driven market. During the past month the dispersion between S&P stocks has risen to 8.4%, above its long-term of average of 5.8% (since 1991).
Figure 1. Number of S&P 500 companies held by ETF’s and passive mutual funds
Source. Wall Street Journal
Active managers who are fundamentally-driven and take conviction positions (such as ourselves) should be well-placed to take advantage of mispriced assets and prove their worth over the long-term. Moreover, during the past few decades we have experienced declining inflation and government bond yields, creating an environment for passives to flourish. We would argue that this rosy environment may change and active investing will remain an important element of the asset management industry.