One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Seth Klarman.
Back in February this year, Klarman released The Baupost Group’s 2016 year end letter in which he discusses the impact of ETF’s on the hedge fund industry and why ETF’s present long-term value investors with a distinct advantage. It’s a must read for all investors.
Here’s an excerpt from that letter:
The hedge fund “industry” has grown massively, recently hitting $3 trillion in AUM, almost triple the 2005 level. As a result, competition has become more intense. With any asset class, when substantial new money flows in, the returns go down. No surprise, then, that as money poured into hedge funds, overall returns have soured.
From January 2010 through December 2015, the HFRI [hedge] Fund Weighted Composite Index shockingly gained only 23% compared to 108% for the S&P and 138% for the Nasdaq Composite. In 2016, the same hedge fund index returned roughly 6%, again significantly lagging the market. (And it’s worth noting that reported hedge fund index returns may be biased upward because of the index’s reliance on self-reporting by funds.) In 2015 and again in 2016 many prominent hedge fund managers posted particularly large and headline-grabbing losses, putting an unfortunate exclamation point on what has been a protracted period of dismal performance for the hedge fund industry as a whole.
Taking all this into account it may have been a greater accomplishment for Baupost to earn a high single digit net return with quite limited risk in 2016 than it was for us to have earned higher returns in prior years.
After the last several years of disappointment, many institutional investors have concluded that hedge funds, in aggregate, are no panacea. To many, hedge funds have come to seem like a failed product, and the financial media have increasingly and rightfully fixated on hedge fund fees and returns. Aggregate data suggest that capital flows have started to reverse.
Hedge funds experienced outflows exceeding $50 billion over the course of 2016, and in the third quarter more hedge funds closed than opened. Moreover, several prominent bellwether institutional investors have announced plans to scale back their allocations to hedge funds. If this trend continues and the industry contracts significantly, the markets could become more inefficient and available alpha could be split across fewer competitors, leading to enhanced returns for the most capable survivors.
Ironically, as the market becomes increasingly expensive, hedge fund fever has waned, and investors have gotten excited about market-hugging index funds and exchange traded funds (ETFs) that mimic various market or sector indices. At mid-year, 11.6% of the S&P 500 was held by index funds and index ETFs, up from 4.6% a decade ago. This trend away from active stock picking, if anything, accelerated in 2016. ETFs now exceed $3.2 trillion in assets and are changing the financial landscape. Over the last 12 months, while $131 billion has flowed out of all U.S. mutual funds, $249 billion has flowed into U.S. ETFs. Meanwhile, five of the world’s seven most heavily-traded equity securities are ETFs.
But ETFs are not without their own risks. According to the Financial Times, “Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.” Large concentrations of ownership in a small number of ETFs has left corporate ownership increasingly concentrated. And because of the high volume of ETFs, short-term trading has become even more dominant. John Bogle, the founder and retired CEO of Vanguard, points out that 12% of a typical stock turns over each year, compared with 880% turnover for ETFs. Similarly, Nikolaos Panigirtzoglou, a global markets strategist at JP Morgan in London, warns that the inflows into ETFs will make markets more brittle, susceptible to more severe crashes, and less efficient.
One of the perverse effects of increased indexing and ETF activity is that it will tend to “lock in” today’s relative valuations between securities. When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).
Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings. Conversely with money pouring into market indices, stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it. This should give long-term value investors a distinct advantage. The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.
Given this confluence of competitive forces, what can we say about the outlook for Baupost over the next several years? No matter what, we will have to work hard and remain focused yet agile. Fortunately, our goals are different than those of most other investors. Founded as an expanded family office, we see ourselves as long-term stewards of capital with a focus first and foremost on the preservation of capital, and only thereafter on earning a return. If competitive forces make it harder to earn a return, you won’t see us reaching for yield or ramping up risk. We intend to maintain our focus on downside protection, and we will wait as long as necessary for bargains to arise.
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