According to investment officers, asset managers and economists of the world’s biggest banks, the immediate future of our investment portfolio is benign. Most predict small gains or losses for 2022, expecting the Standard & Poor’s 500 industrial index to not deviate too far from where we are now, at the beginning of the year.
Given that most advanced economies are still awash with freely available money and hence leverage, pundits expect heightened volatility though. Much sound and fury, signifying nothing. This seems overly optimistic if one bears in mind how stocks have soared way past any fair value since the momentous slump of 2020.
Most central banks envisage a tightening of monetary conditions and governments seem adamant to reduce fiscal support. Even Biden’s Build Back Better Act worth two trillion US dollars is unlikely to materialise, torpedoed with stubborn regularity by Democratic Senator Joe Manchin. As the tidal wave of free money for the markets ebbs away, one would expect a substantial decline in asset prices.
The advance of asset prices was, after all, the result of unprecedented liquidity. Broadly available leverage turbo-charged any investment bet, even the most outlandish. A cash-fuelled climate lifted all boats, even those not yet built or already sunken.
The idea that skilled asset managers who base their investment decisions on meticulous balance sheet valuations could outperform aggregate markets looked increasingly outdated. Their sizable fees too weighed heavily on a performance which was at best mediocre, and in most cases inferior to market averages.
The growing popularity of index-tracking, exchange-traded funds (ETFs) that cannot be bothered with financial analysis but merely copy the building blocks of whole markets, seems therefore unstoppable. These “passive” investments have rightly gained popularity. Big investment houses have over the years created a wide array of ETFs, from green investments to commodity-based index trackers, covering themes like crypto currencies, highly speculative tech investments and even bespoke indexes.
The gaining clout of ETFs and their increasingly assertive demeanour does not imply a march towards riskless passivity, but the shift of responsibility from the asset manager to the retail investor, who has no one to blame but the markets.
The most popular ETFs are carbon copies of the US stock market as represented by the S&P 500 index. I always felt silly never to have invested in any of these, since their performance has clearly beaten my own stock picker’s dabbling ‒ often by a wide margin.
My portfolio, as I have written before, contains many laggards and losers, which I always felt hesitant to sell, against better evidence. Adhering to the principle of cheap valuations I often stuck to investments which were not brilliant buying opportunities, but stocks with an unpromising future. I have mentioned European banks, oil companies, and even worse, oil servicing companies that do the engineering and drilling for Big Oil.
I did not mention my “contrarian” bets in meme stocks like electrical vehicle maker Nikola or the rubber glove maker Supermax, which I bought when the boom for PPE was over, did I? Bets on Canadian cannabis producers proved equally disastrous, with little hope for recovery.
There’s no one to say: Wait. This is too expensive. This is too cheap. Let’s reconsider- Andreas Weitzer
What makes my stubborn refusal of stock market ETFs look even more foolish is their unbeatable tax advantage. While my dividend incomes are usually fully taxed by the tax authorities of a company’s place of listing, most ETFs are domiciled in tax free territories, with head offices in Ireland.
I pay for my stubbornness not only with high brokerage and banking fees, but also with local taxes I should have never paid in the first place, lacking the infrastructure to profit from double-taxation agreements or cumbersome tax refunds.
As I have written here a few years ago, my initial hesitancy to rely on ETFs stemmed from a belief that in times of crisis, when ETFs will be shed by investors in a rush, ETF fund managers will be forced to recalibrate devaluing ETF shares with the underlying assets in real time, probably dislocating asset prices too. Tracking will fail. With the experience of such massive disruptions as happened in spring 2020 it is now clear that major ETFs performed very well, keeping discounts and premiums to the underlying assets at narrow spreads.
My second argument to refrain from ETF investments stemmed from my understanding that price finding mechanisms depend on sellers and buyers to agree on quantity and quality. In a world which has turned 100 per cent passive, with no one actually assessing and pricing anything anymore, price finding must logically become impossible.
Markets in such a world cannot recalibrate. There will be no resistance when prices move upwards and no stops on the way down. No one to say: wait a little. This is too expensive. This is too cheap. Let’s reconsider. Logical, perhaps, but wrong. Despite the growing ubiquity of passive funds, they still represent only a minority share of the markets they set out to mimic.
There’s only one valid argument against stock-market tracking ETFs, I think. It has to do with the feature of market-cap-based indexes like the S&P 500, which apportion a growing slice of the index to companies with rising share prices. The more expensive a company gets, the bigger its presence in the index will be.
We retail investors, however, feel more at home with equal weight investments. When a single investment grows out of proportion with the rest of our portfolio, we want to reduce its size, as we do not wish to narrow our bets. We instinctively hesitate when too many eggs lie in one basket.
I have done so with my Apple shares lately, which I have partly sold to match them with my other holdings. Most index trackers will do the opposite. More money will flow into companies with rising share prices.
The seemingly unstoppable gains of the S&P 500 index over the last year was a boon for investors, who shrugged off the fact that its exalted advance was carried by ever fewer companies. A growing minority of US stocks has peaked already, their share prices in retreat. The S&P 500 Index Fund (SPXKX:US), as published by Bloomberg, has reached an all-time-high at the time of writing, yet it is carried by tech giants forming a major part.
Someone invested in an S&P 500 index is not betting on the future of the US economy as a whole, in a way in which, for instance, the investment fund Berkshire Hathaway is invested, holding traditional assets like Coca Cola, American Express, or BNSF Railways.
Investing in a S&P Index fund is a concentrated, almost exclusive bet on Apple, Microsoft, Amazon, Facebook/Meta, Google-parent Alphabet, chip-designer Nvidia, or electrical vehicle maker Tesla ‒ all of them companies that are eye-wateringly expensive.
This could be a successful investment decision for years to come, outshining my own DIY portfolio botch with aplomb. But it is anything but passive. It is an aggressive bet on a small group of hyper companies, which depend like all of us on a long, unwavering run of good luck.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com