Passive Aggressive

Client Newsletter    Volume XXVII   Number 2   November 1, 2021

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In an article quoted in section IV below, an annual cost of 0.04% is quoted as “nearly nothing” for a stock index fund. Vanguard’s Total Stock Market Index ETF now costs 0.03% per year.  In a typical portfolio, the weighted average fund cost is less than 0.05%, and this includes one higher cost, non-indexed fund, Vanguard’s High Yield Corporate Bond Fund Admiral Class.  This is Vanguard’s “good junk bond fund” which is actively managed and costs 0.13% per year.

Since Vanguard is a true mutual (that is Vanguard is owned by its shareholders), unit cost savings realized as Vanguard has gotten larger are passed on to shareholders in the form of lower annual fund costs.  When I first invested in 1989 its first index fund had less than $2 billion in net assets.  It is my anticipation that Vanguard will become larger and there will be additional cost-saving passed along to us, though at a smaller rate of cost decrease than prior.

Each of us has a different ability to live with uncertainty (risk) and so our investments will be different:

As of March 31, 2021	Clients	John Smartt
Money Market Funds	2.2%	0.0%
Bond Funds	26.0	19.5%
Stock Funds	71.8	80.5%
Totals	100.0%	100.0%

 

Remember each of us has different goals and needs and our asset allocation should fit us and our family. If you have questions about your asset allocation, or your retirement plan investments, I’d be pleased to assist.

 

Performance percentages are per Morningstar.  Amounts in parentheses are percentile rankings (1= best and 100= worst) within category.
Periods ended September 30, 2021	Yr.-to-date			5 Years			10 Years
Total Stock Market Index Admiral	15.2%		(54)	16.9%		(20)	16.6%	(15)
Tax-Managed Capital Appreciation Admiral	15.3%		(52)	17.3%		(12)	16.9%	(6)
Tax-Managed Small Capitalization	20.1%		(26)	13.5%		(24)	15.6%	(8)
REIT Index Admiral	22.2%		(47)	7.5%		(46)	11.5%	(31)
Total Int’l Stock Index Admiral	6.4%		(66)	9.0%		(35)	7.9%	(57)
Balanced Index Admiral	8.3%		(54)	11.4%		(13)	11.2%	(15)
Total Bond Market Index Admiral	-1.6%		(61)	2.9%		(52)	3.0%	(59)
Interim-Term Investment-Grade Bond	-0.8%		(38)	3.9%		(80)	4.3%	(74)
High–Yield Corporate Bond	3.2%		(78)	5.6%		(44)	6.6%	(38)
For comparison, here are several stock and bond benchmarks:
Periods ended September 30, 2021		Yr.-to-date			5 Years		10 Years
S & P 500 (large stocks)		15.9%			16.9%		16.6%
Russell 2000 (small stocks) MSCI World Index		12.4% 13.0%			13.5% 13.7%		14.6% 12.7%
BBgBarc US Aggregate Bond Index		-1.6%			2.9%		3.0%
ICE BofAML US High Yield Master II TR (bond index)		4.7%			6.4%		7.3%

Vanguard mutual funds and ETFs (exchange-traded funds) continue to perform as expected.  I expect each Vanguard fund or ETF, for each ten-year period to be in the top 1/3 before taxes based on low cost, and they ought to be in the top 1/4 (stock funds) after income taxes.

The Vanguard High Yield Corporate Bond fund takes significantly less risk than the average “high yield” (also known as “junk bond”) fund.  The Vanguard fund, which takes less risk, continues to rank reasonably high in the rankings over the last ten-year period.  When the more risky portions of the “junk bond” investment sector are under stress (as they have been recently), the Vanguard fund shines and it is doing so at present.  Over the last ten years, the Vanguard fund has captured almost all of the excess of junk bond returns over good quality bond returns—exceeding my expectation.  I continue to believe that, for tax-deferred accounts, this fund is a reasonable, additional diversification and comprises some of my personal bond holdings.

If you have questions about your investment asset allocation, please contact me.

This article appeared in the October 16, 2021 edition of The Economist magazine subtitled “The unstoppable rise of index funds deserves scrutiny–but not panic.”

“The history of modern finance is littered with ideas that worked well enough at small scale—railway bonds, Japanese skyscrapers, slice-and-diced mortgage securities—but morphed into monstrosities once too many punters piled in. When it comes to sheer size, no mania can compare with that of passive investing. Funds that track the entire market by buying shares in every company in America’s S&P 500, say, rather than guessing which will perform better than average, have attained giant scale. Fully 40% of the total net assets managed by funds in America are passive vehicles, reckons the Investment Company Institute, an industry group. The phenomenon warrants scrutiny.

Index funds have grown because of the validity of the core insight underpinning them: conventional investment funds are, by and large, a terrible proposition. The vast majority of them fail to beat the market over the years. Hefty management fees paid by investors in such ventures, often around 1-2% a year (and more for snazzy hedge funds), add up to giant bonuses for stockpickers. Index funds, by contrast, charge nearly nothing (0.04% for a large equity fund) and do a good job of hugging their chosen benchmark. Given time, they almost invariably leave active managers in the dust.

‘Trillions’, a new book by Robin Wigglesworth, a journalist at the Financial Times, chronicles the rise of passive funds from 1960s academic curiosity to 1970s commercial flop and then runaway success in the 2000s. It estimated that over $26trn [trillion]—more than a year’s economic output in America—is now lodged in such funds. That is more than enough to set nerves jangling, given high finance has in the past built structures that turn out to be too big to fail.

Mr. Wigglesworth, while broadly celebrating this passive revolution, also lays out where the pitfalls might lie. An obvious one is that index funds hand power to the companies that compile the indices. Once-dull financial utilities that reflected the performance of markets, such as MSCI, S&P and FTSE, now help shape them instead. Including a company’s shares in an index can force investors around the world to snap them up. The power of the index is indeed a potential shortcoming. But by and large the weakness is obvious enough for regulators and investors to guard against it.

Another concern is corporate governance. BlackRock, State Street, and Vanguard, the three titans of passive investing, together own over 20% of large listed American firms (among other things). Although one person’s vote makes no difference, active managers who pick shares in a handful of companies will push for them to be well-run. Passive investors whose portfolio includes several hundred names might not be so fussed. That is worrying, given they could control the outcome of many a boardroom spat.

Passive giants respond that they are attentive owners, with staff dedicated to prodding the mange of the companies they own. Better yet for their power to be diffused more widely. That is happening: BlackRock, which on October 13th announced it now manages $9.5trn in assets, plans to hand over some proxy-voting rights to the investors in its funds. This might also alleviate another concern, that companies owned by the same massive passive fund will not compete as energetically, lest their success damage other holdings in their shareholders’ giant portfolio.

The biggest gripe of asset managers is that tracker funds free-ride on stockpickers’ hard work. Even mediocre active funds taken together, help direct capital to worthwhile companies (and away from poorly run ones). Inigo Fraser Jenkins of Bernstein, a broker, once decried passive investing as ‘worse that Marxism’: Soviet planners did a lousy job of allocating resources to promising ventures, but at least they tried. Index funds, however, revel in their passivity.

What to make of this risk? A market dominated by passive investors would indeed kick up concerns over whether capital is going in the right places. But domination is far from the case today. Active managers still play a big role in markets. Retail investing is vibrant (if sometimes over-exuberant). Private equity firms keep public and private valuations largely in line. Venture capitalists are flocking to startups.

Furthermore, the theoretical flaws of passive funds must be set against the very real saving investors have made since they arrived on the scene. The effects of rising passivity are worth pondering, but not reversing.”

Smartt comment: The article addresses one of my concerns about indexing, that if it gets too big, then it will cease to work. More than a decade ago I saw the results of a study which speculated that indexing might be too big to function if index funds owned approximately 85% of securities. At approximately 40% today, we have a ways to go before this might become a problem.

Another possible flaw in indexing actually did occur in Canada late last century. Northern Telecom, a Canadian growth stock grew to be more than 30% of the entire capitalization of Canadian publicly traded corporations. Ordinary index funds had to own this percentage of the stock. This is not proper diversification. Its successor company, Nortel, went bankrupt in 1993.

One of the article’s concerns, that companies both owned by an index fund might not compete against each other to avoid damaging their stock value is, I believe, a non starter. All large companies give their executives (and many or all employees) stock options. This serves to insure that company managements will compete, occasionally too fiercely.

Clients, and my own father, have periodically expressed concern about having “all their eggs in one basket” by owning most all of their investments within a single company, Vanguard. As PriceWaterhouseCoopers is the independent audit firm of Vanguard, and is an accounting firm for whom I toiled for 18 years, I have confidence that material errors will be unearthed and corrected.

So, one of the reasons I may be one of the luckiest guys on earth is that I found Vanguard very early and that Vanguard and the internet allowed me to build a business on a very, very good idea. Low cost, buy-and-hold, broadly diversified, tax-efficient investing works (and I have confidence that it will continue to work. Apparently, The Economist agrees with me.).
This article appeared in the October 16, 2021 edition of The Economist magazine subtitled “The unstoppable rise of index funds deserves scrutiny–but not panic.”

“The history of modern finance is littered with ideas that worked well enough at small scale—railway bonds, Japanese skyscrapers, slice-and-diced mortgage securities—but morphed into monstrosities once too many punters piled in. When it comes to sheer size, no mania can compare with that of passive investing. Funds that track the entire market by buying shares in every company in America’s S&P 500, say, rather than guessing which will perform better than average, have attained giant scale. Fully 40% of the total net assets managed by funds in America are passive vehicles, reckons the Investment Company Institute, an industry group. The phenomenon warrants scrutiny.

Index funds have grown because of the validity of the core insight underpinning them: conventional investment funds are, by and large, a terrible proposition. The vast majority of them fail to beat the market over the years. Hefty management fees paid by investors in such ventures, often around 1-2% a year (and more for snazzy hedge funds), add up to giant bonuses for stockpickers. Index funds, by contrast, charge nearly nothing (0.04% for a large equity fund) and do a good job of hugging their chosen benchmark. Given time, they almost invariably leave active managers in the dust.

‘Trillions’, a new book by Robin Wigglesworth, a journalist at the Financial Times, chronicles the rise of passive funds from 1960s academic curiosity to 1970s commercial flop and then runaway success in the 2000s. It estimated that over $26trn [trillion]—more than a year’s economic output in America—is now lodged in such funds. That is more than enough to set nerves jangling, given high finance has in the past built structures that turn out to be too big to fail.

Mr. Wigglesworth, while broadly celebrating this passive revolution, also lays out where the pitfalls might lie. An obvious one is that index funds hand power to the companies that compile the indices. Once-dull financial utilities that reflected the performance of markets, such as MSCI, S&P and FTSE, now help shape them instead. Including a company’s shares in an index can force investors around the world to snap them up. The power of the index is indeed a potential shortcoming. But by and large the weakness is obvious enough for regulators and investors to guard against it.

Another concern is corporate governance. BlackRock, State Street, and Vanguard, the three titans of passive investing, together own over 20% of large listed American firms (among other things). Although one person’s vote makes no difference, active managers who pick shares in a handful of companies will push for them to be well-run. Passive investors whose portfolio includes several hundred names might not be so fussed. That is worrying, given they could control the outcome of many a boardroom spat.

Passive giants respond that they are attentive owners, with staff dedicated to prodding the mange of the companies they own. Better yet for their power to be diffused more widely. That is happening: BlackRock, which on October 13th announced it now manages $9.5trn in assets, plans to hand over some proxy-voting rights to the investors in its funds. This might also alleviate another concern, that companies owned by the same massive passive fund will not compete as energetically, lest their success damage other holdings in their shareholders’ giant portfolio.

The biggest gripe of asset managers is that tracker funds free-ride on stockpickers’ hard work. Even mediocre active funds taken together, help direct capital to worthwhile companies (and away from poorly run ones). Inigo Fraser Jenkins of Bernstein, a broker, once decried passive investing as ‘worse that Marxism’: Soviet planners did a lousy job of allocating resources to promising ventures, but at least they tried. Index funds, however, revel in their passivity.

What to make of this risk? A market dominated by passive investors would indeed kick up concerns over whether capital is going in the right places. But domination is far from the case today. Active managers still play a big role in markets. Retail investing is vibrant (if sometimes over-exuberant). Private equity firms keep public and private valuations largely in line. Venture capitalists are flocking to startups.

Furthermore, the theoretical flaws of passive funds must be set against the very real saving investors have made since they arrived on the scene. The effects of rising passivity are worth pondering, but not reversing.”

Smartt comment: The article addresses one of my concerns about indexing, that if it gets too big, then it will cease to work. More than a decade ago I saw the results of a study which speculated that indexing might be too big to function if index funds owned approximately 85% of securities. At approximately 40% today, we have a ways to go before this might become a problem.

Another possible flaw in indexing actually did occur in Canada late last century. Northern Telecom, a Canadian growth stock grew to be more than 30% of the entire capitalization of Canadian publicly traded corporations. Ordinary index funds had to own this percentage of the stock. This is not proper diversification. Its successor company, Nortel, went bankrupt in 1993.

One of the article’s concerns, that companies both owned by an index fund might not compete against each other to avoid damaging their stock value is, I believe, a non starter. All large companies give their executives (and many or all employees) stock options. This serves to insure that company managements will compete, occasionally too fiercely.

Clients, and my own father, have periodically expressed concern about having “all their eggs in one basket” by owning most all of their investments within a single company, Vanguard. As PriceWaterhouseCoopers is the independent audit firm of Vanguard, and is an accounting firm for whom I toiled for 18 years, I have confidence that material errors will be unearthed and corrected.

So, one of the reasons I may be one of the luckiest guys on earth is that I found Vanguard very early and that Vanguard and the internet allowed me to build a business on a very, very good idea. Low cost, buy-and-hold, broadly diversified, tax-efficient investing works (and I have confidence that it will continue to work. Apparently, The Economist agrees with me.).