Covenant Weekly Synopsis for May 17, 2019

May 19, 2019

Last Week Today. German Bund yields went negative (again), reaching a 1.5-year low of –0.106%. | President Trump and his team began moving pieces on the global trade chessboard for countries not named “China”: tariffs on European and Japanese autos delayed for at least six months; steel/aluminum tariffs removed for Canada and Mexico; Turkish steel tariffs cut to 25% (from 50%). | China instituted retaliatory tariffs on $60 billion of US imports and increased their rhetoric against the US Indeed, the government is even allowing nationalistic voices to rise in the tightly controlled media for the first time in this standoff, a move that will complicate trade negotiations for both sides as “saving face” will become a more prominent theme for China.


Global risk assets took it on the chin Monday as negative trade headlines caused investors to head for the exits (Global Equities -1.9%, S&P 500 -2.4%). However, investors digested the evolving situation, and by the end of the week, equities had rallied back to regain much of Monday’s losses. Developed International Markets closed the week in positive territory, while domestic equity indices ended the week down less than 1%. At the half-way mark in May, equities are in negative territory with US and International Developed Market stocks down 2.4% – 2.8%, while Emerging Market equities are bearing the brunt of the pain at -7.6%, owing to their China exposure. Considering the risk-off mood, investors moved to the haven of US Treasury Bonds, pushing yields down across the maturity curve. The yield spread between 10-year and 3-month bond maturities went slightly negative mid-week (i.e., “inverted”) again, as bond traders continue to believe the Fed’s monetary policy is too tight.

For specific weekly, month-to-date and year-to-date asset class performance, please click here.

157. This is the 157th edition of the Weekly Synopsis. Why mention the number? Well…. truth be told, we didn’t notice when we crossed the 100th edition. Our hope in writing these pieces (nearly) every week is to offer a resource for improving financial literacy with regards to current market events, the economy, investment principles, investment strategies, and such. Our intentions are not purely altruistic, as we learn by studying and writing about the various topics each week, including the ones that don’t make it into the weekly missive. We will continue sharing our thoughts and research and hope you will keep reading (and please share with anyone else you think would be interested) because intellectual curiosity and lifelong learning are genuinely about the journey and not the destination.

Passive vs. Active Management Part Deux. We wrote about this topic, back in April. However, given the continued large flows out of active and into passive investment strategies, it’s worth revisiting. This discussion of Active vs. Passive is more detailed as it’s informed by a recent analysis from Fidelity, which supports our original thesis, but provides a more robust analytical framework.

Since 2014, investors have pulled more than $500 million from Active strategies, while Passive strategies gained some $1.5 trillion in assets. The reason for the flows is rather evident as investors are prompted continuously by factually accurate, but technically weak, charts, and graphs like the one below that highlights passive investing’s superiority.


Source: Fidelity Investments

A few things to note on this chart:

  • The benchmark is the S&P 500 Index (gray bars). As we pointed out in our April piece, you cannot invest in an index. You can only invest in a vehicle that provides investment results that are intended to track an index. Indexes are “paper portfolios” – they exist in theory, but do not incur the frictional costs of investing, including buying/selling securities, accounting, administration fees, etc. Even vehicles with no management fees (e.g., the latest ETFs) typically lag their respective benchmarks because they are subject to these real-world costs.
  • More importantly, in the chart above, Active Management is represented by the “Average” fund. Who invests in average funds? While one may not be able to consistently select the top decile or quartile funds, with a little effort, it’s relatively easy to avoid the bottom quartile funds which drag the average down.
  • This chart and, indeed, most of the industry research is limited to data on Passive vs. Active strategies investing in U.S. Large Cap stocks. From this limited data set, investors (aided and abetted by most forms of media) make the leap of logic that if Passive outperforms Active in U.S. Large Cap stocks, it must be true everywhere else.

Fidelity’s research corrected for some of the common deficiencies cited by the media and included a couple of simple assumptions in filtering the universe of Active strategies: exclude strategies with the highest fees in each category (i.e., in the top quartile); and eliminate strategies with a Morningstar rating of only 1 or 2 stars.

The results of Fidelity’s work run counter to the media’s narrative, as highlighted in the chart below. In this chart, Active strategies are represented by the “green” dots and Passive investments by the “blue” dots. The horizontal line at 0% represents the benchmark index for each category; thus, the area above the line represents outperformance relative to each category’s benchmark.


Source: Fidelity Investments

Active management outperformed Passive in 11 of the 19 investment categories. From the results, certain investment categories offer a better opportunity for Active management to outperform. These categories share characteristics such as high dispersion (i.e., the stocks within the category tend to move independently of one another by a significant amount), lower competition, and/or less analyst coverage.

On the flip side, it’s not surprising to see that Active Management struggled to outperform Passive in U.S. Large Cap stock categories (e.g., Large Growth, Large Blend, and Large Value). Remember, this is the same category from which the media has been drawing its conclusions regarding the superiority of Passive over Active investing.

Finally, Fidelity’s research concluded that the performance tradeoff between Active and Passive is highly cyclical. Interest rates and the economic environment are likely contributing factors as the data implies that Passive strategies tend to outperform in periods where the economy is reasonably stable, and interest rates are low and/or falling. In these periods, companies’ cost of capital is low obfuscating the differences between good businesses and bad businesses. By contrast, in more challenging economic environments, or when the cost of capital is rising, investors are better able to differentiate between the wheat and the chaff.

Indeed, the last 10-year period of declining rates and a generally stable economic environment has been tailor-made for passive strategies. Consider that 37% of all Russell 2000 Index companies are not profitable ten years into a bull market (Source: Fidelity Investments). It stands to reason that if the cost of capital begins to rise, or the economy turns south, an Active strategy that differentiates between profitable companies and unprofitable ones will outperform a Passive strategy that purchases all 2,000 names in the Index.

In summary, Covenant’s position in the Active vs. Passive debate is to rely on Passive management for the most efficient markets but to consider Active management options in sectors or geographies where markets are less efficient. However, a lack of market efficiency only offers a clue for where to begin searching for Active strategies. Because Passive strategies offer exposure at a low cost, any Active manager that makes it into a portfolio must exceed high standards. While historical performance is an important consideration, it is only one part of the selection process. Qualitative assessments of the strategy, investment process, buy/sell disciplines, and the people involved play a more significant role than is generally recognized.

Be well,