ETF Edge - September Pullback, Stock Picking & Active vs. Passive

Episode Date: September 21, 2020

CNBC’s Bob Pisani spoke with Dave Nadig, chief investment officer and director of research at ETF Trends and ETF Database, Nick Colas, co-founder of DataTrek Research, and Larry Swedroe, chief research officer at Buckingham Wealth Partners and co-author of “The Incredible Shrinking Alpha. They discussed the markets, why stock-picking has a terrible track record and why it's only getting worse. In the 'markets 102' portion of the podcast, Bob discusses the dynamics behind active and passive strategies. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you're in the right place. Every week, we bring you interviews and market analysis, and we break down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll talk about the Monday market mayhem, why stock picking has a terrible track record, and why it's only getting worse. That's according to one expert who's been crunching the numbers. Here's my conversation with Nick Colis, founder of Data Trek Research, Dave Knox. CIO and Director of Research at ETF Trends and ETF Database, and Larry Swedro, the chief research officer at Buckingham Strategic Wealth and author of the new book, The Incredible Shrinking Alpha.

Dave, we're approaching a 10% correction in the S&P 500. Any thoughts here on what's going on? We seem to be rotating for a few days. And now some of the reopening names like the industrials are weak today. Can you make sense out of this trading activity? as it applies to ETFs? Yeah, I mean, we obviously have a lot of different things going on. Clearly, there's some concern from a global perspective that reopening is not going to go as smoothly as we were hoping. So what we're seeing is a repricing of a lot of stocks that, frankly, ran way ahead of their fundamentals, trading really based on a bit of a poly in a hope for how both the U.S.

and the global economy was going to reopen. That hasn't happened. And frankly, smart traders have known it. We've seen things like, you know, NASDAQ 100 mini futures, just. almost unprecedented put volume there, folks really try or negative volume on the futures, folks really making the bet that tech is going to roll over. And frankly, until we see a real base in those core tech names at the top of the market cap spectrum, I don't see how we find a base. So the important thing here, Dave, just to finish on, I want to apply this to the

ETF business, very heavy volume today in a lot of the tech-oriented ETFs, but also in the cyclical oriented ETF, your industrials, for example, and real estate investment trusts, also very heavy volume. Those have held up very, very well, the reeds, the industrials, is a reopening play for a couple of months now. This is one of the worst days we've seen in a long time for them. So when I see big down day on very heavy volume after a couple of months of general outperformance, it tells me that some people are clearly betting that the reopening story is not doing as well. Yeah, and I think it's also, you know, we're talking about the heavy volume on a down day here. It's worth pointing out a lot of those big up days we've seen since the March bottoms have been on pretty thin volume.

And so I do think that this is a market that has not been monolithic. There have been different factions of traders in the market expressing different opinions. And what we're seeing is some of those come home to roost. I don't think this is, you know, a Robin Hood day trader story necessarily. But when you look at things like what's going on in the options market and you see the volume of single contract trades. It's hard not to believe that we've got a lot of retail investors who've just had their first experience of what it's like to ride something down 10%. Whether those folks are willing to come back in with that money when they find a bottom, I'm a little skeptical.

Well, what do you think, Nicole, is you being a very data-oriented approach to your investment methodology? What are you telling clients right now about what's been happening in the last week or so, but particularly today? Yeah, Dave's covered a lot of the important points, and I think those are entirely valid. The one thing I would add is we do a lot of historical analysis, and I think it's hard not to see some ghosts of 2008 in what's going on right now politically in terms of needing further stimulus for the economy, but being tied up in a lot of election year issues, you know, both on the hill and in the White House. And as a result, we're getting a delayed necessary fiscal reaction. And I think markets are beginning to understand that's going

be a feature of the landscape now until election day and possibly beyond. Yeah, I think it's very clear that we have questions about the reopening story. Look what's going on in Europe. We have questions about China trade that's out there. We've got questions about a little jitteriness about the elections that are out there. And some questions about the valuation story applied to technology stocks. I think all of this is perfectly understandable when you see the big run-up that we had in the earlier part of the month. I want to move the conversation over to Larry Swaydrow right now.

And it's very simple, folks, why I have Larry on. Stock picking has a terrible record, and it's getting even worse. Now, Larry is the chief research officer over at Buckingham, Wealth Partners. He's one of the experts in the world on passive versus active management. His new book, The Incredible Shrinking Alpha, basically concludes, active isn't working, hasn't been working, and it's getting even worse. Larry, your key finding is that stock picking is bad and it's getting worse. I said a couple times.

Why can't active management outperform? Can you make it just simple for us? Yeah. First of all, active certainly can outperform. It's that it's highly unlikely to do so, as the research shows. And there are a couple of simple reasons. One, the markets are pretty efficient. They don't make lots of pricing mistakes

because 90% of all trading is done by the big institutional investors. investors, people from Goldman Sachs and Morgan Stanley and Renaissance technologies, they don't make many mistakes in pricing assets. The second thing is there aren't a lot of victims to exploit. An active manager is going to outperform. They're going to do so by exploiting some dumb retail money. The problem is, 70 years ago, 90 percent of trading was done by individuals holding their stocks in their brokerage accounts.

Today, it's more than 90% is institutional on most days. So who are exactly the victims if Goldman Sachs is buying, then J.P. Morgan may be on the other side of that trade. And the last is the competition is just getting so much tougher because the people who run money today at these big institutions are all PhDs in the top NBA programs or world-class scientists or mathematicians. Yeah. It's really quite remarkable, the numbers. You know, S&P does a study on this every year, as you know. The last one they did, 85% of large-cap managers underperform their benchmark after 10 years and 92% underperform after 15 years. That's a pretty poor long-term track records. But everybody always brings up Peter Lynch and Warren Buffett and their ability to outperform. There are a few superstar managers. What was their secret? Or is it now? not possible to be a Warren Buffett anymore?

Yeah, they certainly had a secret sauce, and what has happened is the academics have basically reverse-engineered it, trying to identify whether they're common traits or characteristics of stocks that these superstar investors, say, from Graham and Dodsville would buy, and they found out that they bought high-quality stocks that also had relatively low P.E.'s. which you can do in a systematic way, which is what many ETFs do, so that it can be replicated. In fact, all the funds, my firm invests in the same types of stocks that Buffett bought, doesn't take anything away from their great success. They figured it out 50 years before the academics.

But everyone can access these types of funds or stocks today. Yeah, you know, Nick, as I said, Data Trek, one of the most data-oriented firms appropriately that I know on the street. You've written about this before. Does your research broadly support Larry's conclusions as well? Or do you have any points you want to add to this? Where do you stand on all of this? Well, first of all, Larry is absolutely right as far as the macro comment that it's extremely hard to outperform. I would add two comments to it.

The first is, you know, the hey, they have. active management was in the 1990s. It's important to remember that stocks were compounding at 18% a year from 1980 to 1999. And if you added a little bit of beta to a portfolio, you can get a 23, 24% annualized return, charge 200 basis points and basically make as good living as an active manager. The returns of the last 20 years for the S&P have compounded at 6%. And it's a whole lot harder to juice up that to 8% and still be able to charge 200 basis points. No one's going to buy. that product. So the world has naturally migrated to passive management, and rightly so. And it's been much harder to outperform in such a way that justifies a fee. The second thing I'd say is reg FD came into

effect in August of 2000. And that was the regulation that companies had to give information fairly to everybody at the same time. And that really hurt active management, because prior to that, it was possible to call a company and find out how the quarter was going in the middle of the quarter. You can't do that anymore. So it's been much harder to do a simple, arbitrage of information to make an excess return. I think that's a very good point about Reg FD. It's amazing what a little bit of inside information, that's a legal term, but a little help from the company will do for an analyst and how they're calling the stock at the moment.

Dave Naugge, people may wonder, what does this all have to do with ETS? But it matters a lot for ETS because actively managed ETSs are now having a moment in the sun, aren't they? Yeah, I mean, it's been a big year for active ETFs. I think people think all ETFs are indexed. We actually have about 350 ETFs that are actively managed, both bond and stock ETFs and some derivatives focused ETFs. And it's been a decent year for them. They pulled in about $31 billion into those active strategies. And we've seen a lot of traditional active players coming to the market. T. Roe Price had a good launch this year. American Century had a good launch, Fidelity. The list goes on and on of folks who are trying to. to get into this game. I do not dispute the math at all. You know, Larry's 100% right. It is vanishingly small, the number of folks that will be successful. And whether that's skill or luck, I think, you know, people can debate till they're blue in the face. But the story has been overwhelmingly this shift from active mutual fund assets towards passive indexes, whether they're in an ETF or

mutual fund basis. And just to put that in perspective, right now we're looking at about $8 trillion that is indexed in some way here in the U.S. versus about $12 trillion that's in actively managed mutual funds. So it's rapidly becoming parity in terms of what most individual investors are doing in terms of going towards that passive, more predictable source of returns. Yeah. Larry, let me bring you back in here. It seems like your point about Buffett is that he discovered an investment style,

what we call factors today that worked a long time ago, and he discovered it maybe earlier than most other people, Graham Dodd, of course, and Buffett. And that is values sort of combined with quality. We call these factors today. And I think your point is they were brilliant in discovering this, but anybody can replicate that today. It seems like being the first of that strategy is what matters. Is that correct? And are there any other strategies that have been successful that academic research is. is uncovered or uncovered besides the value and the quality factor or metric? This has been the big problem for active management, as academic research continues to advance our understanding of how these great managers were delivering alpha, and then it gets converted into Betabob. So now we have in the literature over 400 factors that have been identified,

which is why my colleague, Andy, Burkin and I wrote a book, your complete guide to factor-based investing, to help investors manage their way through this factor zoo. And we narrowed that down to just five equity factors. So we have not only quality and value, but there is a size premium, a market beta premium, which Dave alluded to earlier.

You have a profitability factor and a, momentum factor as well. And there's one that almost made our test. We had one little hiccup with it, if you will. That's a low beta premium. A low beta has actually delivered out performance relative to its risk adjusted, but it only does so when it's in the value regime. So these low beta stocks look like value stocks about two-thirds of the time. But it's become so popular today that they now have become growth stocks pushing the evaluations up. And the history says it doesn't work so well when it's in that regime. Okay.

So the problem I have here is, so you've identified several factors, momentum, quality, what we call associated with generally better earnings overall. What else we got? We've got several other ones. Size, momentum, you mentioned. Yeah, here's the problem I have. Once everybody identifies it, everyone copies it, and so it's not as effective anymore. Isn't that the key point about all this?

Everyone copies it, and its value as an outperformer goes down. Well, two things you need to distinguish. One is that if everyone copies it, then the premiums can shrink because money flows into those assets, driving their prices up. You don't change the earnings of the companies. so then the premiums can shrink. But everybody, Bob, knows about market beta being a risk premium. Stocks are riskier.

It doesn't mean that the market beta premium goes away, but it can shrink. It's regime dependent. When you have a non-risk-based factor, such as momentum, which is purely behavioral, there it is much more likely the premiums can shrink or even disappear, although what are called limits to arbitrage, which basically reflect the high cost of shorting and the great risks of shorting can allow even behavioral anomalies to persist. So I know this sounds like a dumb question, but if active management doesn't work, why is it so popular? I mean, why do we keep talking about it? Yeah, well, John Bogle, I think, said a best.

Nobody likes to be average, and that's what Wall Street tells you we could do. better than average, which is cost as possible to do. But the fact is that's one of the big lies from Wall Street is if we know that if you just passively invest in these index funds, you get market returns, which means you outperform or get higher than average returns than the vast majority of active investors. And by the way, those 85 and 92 percent figures you touched on are all pre-taxed. And active management's greatest expense is not its expense ratio in most cases. It's not even its trading costs.

It's often taxes, which is why you're seeing a big flow to active ETS to at least reduce that drag because the ETF version will be much more tax efficient. Yeah. And, you know, Dave, Larry's too kind to mention this. But in discussions I've had with him before, he said, another reason it's so popular is the financial press, which is you, Bob. You guys keep talking about fund managers that outperform that don't really outperform over long periods and you make stories out of things just to have stories. Is there some truth in the idea that the financial press is

complicit in all of this? Oh, absolutely. I mean, I think we are all complicit in this because the reality is if we were all just buying, you know, the Russell 3,000 and then forgetting about it for a year, we would get rid of an entire source. of entertainment, right? I mean, I think people forget that financial television, financial news, for many people, it's not just about earning money. It's a hobby. And there's nothing inherently wrong with that. You just need to understand that that's what you're doing. So I always say this when people say they want to go pick stocks or they want to run their portfolio. That's great. If that helps you learn about the market and that helps you for sleep at night because you're doing that,

that's great, but don't expect, don't have the assumption that you're somehow going to do better than a passive portfolio because the math is just not with you. But it doesn't make it wrong. It just means it's non-economic. Yeah. Nick, I want to bring you in on another part that Larry talks about a lot, and that's the dumb money. Many, many years ago, you know, 80 or 90% of the trading was done retail traders amongst each other, essentially dumb money. And today, 15% maybe is retail and the rest is professional. So the pool of dumb money has been shrinking. I wanted to ask you about this in the context of Robin Hood, Nick. I think Larry would say that there's a small pool of retail investors trading with professionals. And Robin Hood traders,

just like most retail, have no real edge. They don't have a lot of knowledge of the companies. And ultimately, a lot of this is going to end badly, just like it did in 2000. Nick, what is your opinion of the Robin Hood trend and what Wall Street likes to derisively call dumb money? Yeah, it's an interesting thought. I mean, we have to remember that every capital market begins the same way. It always begins with retail doing it first. It was the same with options in the 1970s. And then over time, you get more professional investors coming in and the pricing gets narrower and better and the market becomes more efficient because they're bringing more resources to bear. So I'm not uncomfortable with the idea that everything begins as a retail and then

moves to institutional. That's the way it always goes. As far as the Robin Hood money being dumb money, I'm kind of careful on that notion because for years we complained that retail investors weren't getting involved in the stock market. The percentage of the U.S. households that own stock was declining. And then here we have a sudden flare-up of people actually being interested in the stock market. And we can't kind of have it both ways. Either you want people involved in the market, in capitalism and understanding how this thing works, or you want them out. And you can't have it both ways. I personally think it is a good thing that Robin Hood traders are coming into the market, because even if some blow up and some certainly will, you still have more people interested in

the capital markets, and that is net net a good thing, not a bad thing. Yeah, yeah, I agree with you. I think it's wonderful that there's more involved. Even if it is, as Wall Street likes to call it, dumb money. I like to see more people involved, but I'd like to see them get smarter a lot quicker. Larry, let me ask you something. With all of this information that we now have, what should investors do? What do you tell your investors to do? Is there a way to invest simply and stay with the market with just a few funds? Is that what people should do right now? Stay with passive? What do you recommend? Give us some advice. focusing on the risk of their portfolio and making sure they don't take more risk than they have the ability, willingness, and need to, which I work through in my book, you're a complete guide to a safe and secure retirement.

And if you really want to keep it very simple, you can basically own a Vanguard Total Stock Market Fund for the U.S., a Vanguard Total International Fund, and own a Treasury bond. or better even yet, build your own portfolio of CDs. And that's all you need. So you can be highly involved in the markets without being a Robin Hood and day trading. And the second thing I would just point out, Bob, is this. Every time one of those Robin Hood investors is buying the stock, they should stop and ask themselves this question.

Who's on the other side of the trade that's selling that stock to me? and since we know 90% of the trading is done by big institutions, they are likely have far more information to me. So why am I buying when they're selling? As you pointed out, if they don't have an edge over these big institutions, they're likely playing a loser's game, which they should stop playing, unless it's purely entertainment, like we go to the casinos and they. Sure.

So you're saying, and this is an interesting point, Instead of owning like 30 ETFs or 30 stock funds, I get this all the time, portfolio construction from retail investors. Owning like Vanguard Total Stock, Vanguard International, and either Vanguard Total Bond or CDs, something like that, obviously depends on the waiting, but we'll get you just as much performance as if you own 30 or 40 ETFs. Does the research indicate that by and large? Yeah, absolutely. And then if you want to try to improve your returns and beat the market, you could do so without trying to buy individual stocks. You can tilt your portfolio to these factors that have evidence over the long term of persistence pervasive. They don't always work, which is why you want to diversify. And you need discipline. So you can add value funds and momentum funds and quality, profitability based upon your belief in these factors, just like Warren Buffett. He doesn't own a total market fund. He buys value stocks that are quality. Yeah, all right. Okay, we've gone long, but before I let you go, this is a fascinating discussion. It goes to the very heart of investing. I always get asked

about the high-frequency traders. You know, Bob, what about Renaissance technologies? What about Citadel, for example? Now, these guys are traders in the market. Okay, they trade all day long. They're computer-driven, but don't they demonstrate outperformance of some kind? Larry, do they? And if they do, what are they doing? Yeah, they are certainly generating alpha, number one. There aren't many of them. They get a big advantage in speed and information with all our high-speed computers,

and they're exploiting to a great degree, one, all the other active managers in their trading costs. They can front-run them. And they're exploiting the dumb Robin Hood investors. That's where their edges. They're not generally trying to pick stocks, time the market. They're trying to exploit mostly micro inefficiencies, which they're able to do. By the way, one way to stop that would be to put a very small transactions tax on, which I think the government should be doing and use that to fund the SEC and make it a stronger, better organization.

but a very small tax. Now, that is a debate for another day, but I think you made a very good point. They're not stock, the high frequency guys are not stock pickers, but they are exploiting micro inefficiencies. I love that word, micro inefficiencies in the market. We've gone long, folks, and I'm sorry about that, but this is just a great discussion. Now it's time to round out the conversation with some thoughtful analysis and perspective to help you better understand ETFs.

This is our Market's 102 portion of the podcast. Today we'll dig a little deeper into the dynamics behind active and passive strategies. As always, my producer, Kirsten Chang, joins me. Bob, in discussing my active management remains popular, Larry Swedro says that the financial press, including even CNBC, is partly responsible for its popularity because the media likes to talk about market gurus and superstar active managers were outperforming, even if only for a short while. Do you agree that the financial press is part of the problem?

Kirsten, I'm not sure if the financial press is part of the problem, but I think it's very clear that the financial press goes along with this idea. And I think Larry is correct. I think that every day the financial press has got to get up, just like the press that covers other parts of the world and figure out what's going on. The problem with news is generally news is assumed to be exactly what's happening today. what's moving things, particularly what's moving markets for the financial press. So it's very easy to get caught up in, for example, what's outperforming, what stocks are outperforming. Okay, it's a very easy step from there to say, okay, what kind of mutual funds are outperforming, and by extension, well, somebody's actively managing something somewhere, what funds and what active managers

are doing better than others. And so you get into what we used to, we used to, to call the horse race. Who's winning and who's losing? Not just whose stocks are winning, but what people are winning and losing, because people are behind the horse race, those who are trying to outperform. So the problem is that there's a bit of a, the nature of the news is, by definition, can be very short term. And if you are sitting there looking long term, and I'm talking about many years, of course, that's the most important kind of investment advice you can give. You can't do it every day. You know, I always like to say that giving advice on what kind of portfolio you should construct,

not just what stocks, what mutual funds and what ETFs you should have is the most important thing in the world. But, you know, it's often on the third page of the financial press, mutual funds and what's moving. Why is it there? Well, because, you know, the editors who are there don't consider that any kind of breaking news. So it's the nature of the news business that's part of the problem. I don't think there's an act of conspiracy on the part of the financial press to deny that long-term passive investing outperforms and does better. And for very clear reasons, managers themselves cannot outperform the market over very long periods. Still, we focus on managers who say, oh, they've outperformed for three years.

Professionals know three years, it can be simple luck. usually is. And even with that, very few managers outperform for every three years. So yes, the financial press is, to some extent, part of the problem when people like Larry complained about why active management is still popular and still talked about. But no, I don't think that there's any complicit here because of the nature of the news media itself focused on what's happening on a daily basis. There was also some discussion about the right allocation, the right amount of mutual funds or ETFs an investors should have.

What are your thoughts on that? I have always felt that portfolio construction and understanding portfolio construction and understanding the nature of indexes is a single most important thing you can do as an investor, particularly if you're self-directed, if you decide yourself what's going on. So people always ask me, this is a very common question. if you only had one fund to invest, what would you do? And, you know, if you talk to investment professionals, or go to a mutual fund site, go to a Vanguard or Fidelity or, you know, Dodge and Cox,

all of these big funds, they have what they call a blended fund, one that combines aspects of stock and bond investing in a single vehicle. So these are the, if you only had one fund to own kind of thing. So Vanguard has a very famous fund called the Wellington Fund, Vanguard. This is a very famous old fund at Vanguard. And it's basically a 65%, 35% stock-to-bond portfolio. And the 65% are generally what you would call high-quality, big U.S. stocks, the apples and the Microsofts and the Amazon's of the world.

And the fund's very famous, and it's fairly cheap. And Fidelity has a similar one. big funds have a similar one. So you want to look like blends. Most people will talk, if you were playing a game saying, okay, if you only had one fund, what would you own? If you only had three funds, the typical game would be to say, well, you don't own a very broad stock fund, like Vanguard total stock, a very broad bond fund, like Vanguard Total Bond, and maybe an international fund. Fidelity and Vanguard, they all own, have international funds. And as well. And with essentially three funds, you could own the investment universe. And one of the

points that Larry Swearro makes, and I asked him very specifically, if you just own those three kinds of funds, say a broad stock fund, a broad bond fund, and a broad international fund, would you do just as well than trying to pick 30 mutual funds or 30 ETFs to cover all the bases? And his answer was, yes, you'd be fine just taking three ETFs, that are out there, or three mutual funds that are out there, the key Larry says, is to make sure they're low cost. And that's part of the problem. If you spend a lot of money for an index fund that's charging you 1%, and there are something that do, believe it or not, you're really going to defeat the purpose of doing that. That's it for today. I'm Bob Bizani. Thank you for listening.

And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC. Thank you.