Frank Thoughts: The Sophistry of ETFs
Frank Boland
December 22, 2021

Bank of America recently published a chart showing the entire history of long-term interest rates. The piece was titled “The 5000-Year View of Rates & the Economic Consequences.” While not from the dawn of time, it is from the dawn of civilization starting in ancient Suma. The chart showed short- and long-term rates through this time period. What amazed me was the statement, “BofA wants you to know that interest rates haven’t been this low in 5,000-years.” That is the reason for active stock manager’s underperformance for the past 15 years; it is not the one percent management fee.  

The management fee issue is a fallacy. One that has been promulgated by this century’s version of modern-day Sophists. Sophistry – as you may know – was a teaching mode taught in Greece during the fifth and fourth BC centuries. Socrates and Plato were two of the more prominent philosophers. Despite their prominence, the philosophy came to be viewed negatively. Sophism became thought of as a false statement that had the appearance of being true. More cynically, it’s an error knowingly committed by one for whatever purpose. To be kind, it could be ignorance by some.

Today the Sophists are not Greek philosophers but 21st century businessmen. In the modern financial world, they use the sophistry of the active management fee fallacy for their own financial gain. This group include lawyers, stockbrokers, insurance salesmen, CPAs, and financial planners. All want a piece of the fee business and present themselves as “financial consultants.” ETFs are their perceived gateway. They posit that active managers have been unable to outperform the S&P 500 for the past 15 years because of the 1% fee; then offer themselves as financial guardians for a lower fee.      

The reason for the underperformance of active management has nothing to do with the fee. It’s the 15-year period of crises driven by a policy of zero interest rates. Long rates have always average 3% (would you lend money for less?) plus whatever inflation currently prevails. During this past economic trauma, the Fed has repeatedly described current inflation as “transitory.” Its stated goal is 2%. With the 30-year treasury currently 1.888%, it’s a long way from the “real” 3% plus the 2% inflation goal. Getting to a very conservative 5% long rate will inflict a lot of pain in the bond market.

The cause of it all: two macro crises occurring almost successively over the past 15 years. Negative macro events always produce fear. Fear leads to the selling of stocks, much as it did in 1929, 1987, and 2008. All stocks are then viewed negatively. There is no dispersion and without dispersion one gets high correlation. (Stocks moving up or down as a group). In the crash of 1929, correlation hit a high of 64% and stayed high for close to 12 years. During the crash of 2008-2009 correlation occurred again in the mid-60s but climbed as high as 80-90%. We are now finishing the 13th year of high correlation.

Normal historical (from 1926) correlation is 26%. It is high correlation which impedes active managers from “beating” the S&P 500 index. When a macroeconomic event in the world occurs, stocks become commoditized. They trade like pork bellies. That changes dramatically as interest rates start to rise on a secular (long-term) basis. It last happened in the mid-1950s when Fed funds were then less than 1% (seem familiar?). Fidelity Investments had already started Fidelity Capital Fund and, in that 30-year period of rising rates, the careers of many famous active managers were launched. Every popular delusion in the investment world ultimately fails. As did Sophistry.

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