Frank Thoughts: The False Narrative
Dave Canal
December 12, 2018

For the past decade, the overwhelming and universally accepted narrative in the investment world has been, “no one can beat the market due to the 1% management fee.”  Nothing could be further from the truth.  The real cause of active management underperformance has been the high, and historically unusual, degree of stock market correlation.  It has been unprecedented. 

Correlation is the degree that stocks move together.  Investors are unaware of this impact on active portfolio management, including many professionals.   For the past 75 years, it has averaged 26%.  In recent years we haven’t been close to that.  It is the single reason active managers have been unable to outperform the S&P 500 for the past 10 years. High correlation – approaching 80-100% at times - is caused by algorithms making immediate directional up/down bets using passive ETF investments.

After a sharp market selloff, there is always a picture of someone – supposedly a floor broker - staring up at a computer monitor with a look of agony on his face.  This is photographic fiction.  No person is executing trades.  Trades are totally done by computers.  Their use has made possible the growth of high-frequency trading (supposed market makers), index funds and ETFs.  Unfortunately, none of these Wall Street products have anything to do with price discovery, which is the reason an exchange exists.   An exchange was never intended for computer gaming.   Yet, these vehicles are now responsible for 75-80 % of daily trading volume and have been obfuscating price discovery.   This has been THE major obstacle to outperformance for active managers.  

A sell off with high correlation is well understood.   It is the equivalent of someone yelling “FIRE!” in the back of a theater.   Everyone gets up and leaves.   No one wants to come in to the theater or can (the buy equivalent).  However, 10 years ago, in March of 2009, everyone could come in.   It was able to happen because of the existence of index funds and ETFs.  Computers made it all possible.  But it has resulted in the commoditization of stocks.   Stocks now go up or down as a group depending on the macro news.  That news often has had no bearing on individual stocks in the S&P 500.   

This monolithic “investment” approach was clearly demonstrated last October.  That month, as interest rates moved higher, all stocks moved lower.   For example:  On October 10th, our portfolio of 43 stocks opened down 1.50% in 60 seconds from the market opening.  Two days later, they all traded UP 1.54%.  Again in 60 seconds.  If the S&P 500 can move more than 1% - up or down in that time frame and we know it can - then it is theoretically possible it could happen 3,600 times a day!   Again, the passive industry’s mantra has been, “active managers cannot beat the S&P 500 because of the high cost of 1%.” That is absurd.   Besides, when was the last time the less you paid for something the more you believed it was worth?  The answer is, undoubtedly, never.

Correlation is now slowly fading as computers approach the speed of light.  As it is increasingly achieved, active portfolio managers’ performance will demonstrate how false that narrative has been.    

-Francis Patrick Boland

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