What caught my eye this week.

Fund managers have bemoaned their benchmarks for as long as I’ve been investing – or at least whenever they’re lagging behind them.

Large cap UK fund managers will try to convince you to ignore BP or Shell or some other big energy stock in the UK market if the oil price soars, for example.

Meanwhile hedge fund fans invariably ask you to look past their (nowadays typically middling) gains to focus on risk taken or volatility endured. Yet as an industry they seem to do this less at the marketing stage and more for the post-mortems.

I could go on, especially given that me and nearly everyone else I know who picks stocks are mentally side-stepping our benchmarks these days too.

Even some dedicated passive investors are making excuses.

Size matters

The cause of this angst is of course the top-heavy US market – and the triumph of the so-called Magnificent Seven tech giants – which we touched upon the other week (see The 7/93 portfolio).

For those napping at the back, here’s an update via John Authers of Bloomberg:

Startling, but some still say there’s nothing to see here. That this sort of concentrated performance happens all the time.

And it’s true that in any particular investing era, a few large winners do tend to be stomping around the top of the index like they own the place.

But what is unusual with this generation of ‘inevitables’ is that they’ve kept at it. Their 2020-2021 market-beating advance was repeated right after their 2022 swoon.

Big but blundering

It’s rare for such dominance to go on so long. As GMO points out in its latest quarterly letter [gated], while the largest firms by no means consistently underperform, over the long-term they tend to trail the average stock:

This lagging makes sense, intuitively. Trees don’t grow to the sky and all that.

Of course mildly big companies become giant companies regularly. Winners do win.

But eventually size, complexity, missed expectations, and disruption by upstarts tends pulls down their future gains.

Which is exactly why the news is full of stories about Elon Musk and Mark Zuckerberg and not John D. Rockefeller the 7th or the CEO of the Dutch East India Company.

Looking at GMO’s graph, whenever it did seem like the biggest trees might keep bolting heavenward and then they didn’t after all, the aftermath was not pretty. Think the Dotcom boom and bust, or the crash of the early 70s.

So it’s all of legitimate concern.

Weight for it

I’ll save my musings on what might undo the dominance of the Magnificent Seven for another day. (It strikes me as potential Moguls material…)

But in the meantime, even passive investors are getting antsy.

Our own passive guru The Accumulator wavered from the true path – aka buy a global tracker for all your equities – in devising his No Cat Food portfolio this week.

And judging from the Monevator comments, plenty of you have similar concerns.

The principle worry for everyday folk is of course that our portfolios will take one between the eyes if and when the big winners finally fall (or fade) from grace.

No wonder! The US market now makes up 70% of a global tracker, and Bloomberg’s graph above illustrates where much of its gains have been coming from recently.

But for those of us who play the naughty active game – whether privately or professionally – there’s also the matter of keeping score.

Which brings me back to the benchmark blues I talked about at the start of this post.

Bench pressed

Fund managers are judged on their outperformance, or more likely the lack of it. The rest of us naughty active investors wonder what our hobby is costing us.

Conor Mac put this well on his Investment Talk blog this week:

So what’s a good compounded annual growth rate (CAGR) for 40 years of work, assuming you invested $10,000 per year?

Opinions on this matter vary, but for the sake of argument let’s say that buying a hypothetical index fund and sitting in it for 40 years would have returned 8% compounded annually.

Suppose after 40 years of hard work you look at your portfolio report and see that you generated a 6% compounded annual return.

One perspective is that you made yourself a small fortune of ~$1.4 million.

Another is that you lost ~$1.4 million because if you had instead invested in the fund you would have earned ~$2.8 million and 4.75 years of your life back.

This isn’t just about ego and beating an arbitrary benchmark, it’s about maximising return and considering opportunity costs.

People want to know if what they are doing is worth their time.

Of course the trite answer is the best stockpickers should have bought the Magnificent Seven companies, sat on them, and smashed their S&P 500 benchmark.

The Mag Seven are undoubtedly some of the greatest (/ least regulated / most monopolistic) companies of all-time, so I’m not being quite as glib as it sounds.

Alas, the best stockpickers also tend to be students of history – and a decent majority are believers in reversion to the mean. This made it hard to buy and hold the world’s first $1 trillion listed companies on their way to their becoming the first $3 trillion listed companies.

At least that’s what I’ve been telling my girlfriend. Who has little interest in my returns and even less so in my investing. I guess it’s been on my mind.

It shifts all the time, but I’ve got only 35% or so in US equities presently. No wonder I’m already lagging in 2024.

(And no honey we can’t finally go to the Maldives this summer after all.)

Of course another flavour of active traders do ride momentum – and they would have been buying these stocks accordingly.

Momentum works brilliantly until it doesn’t though, and it’s more easily done within a computer model than lived in reality.

At least that’s my excuse.

Passive violence

To return to passive investing, its critics also hold up momentum as one of their grudges against index-tracking (and never mind indexing’s superior returns).

Veteran hedge fund manager David Einhorn has even been arguing that the markets are ‘fundamentally broken’ due to passive investing:

“All of a sudden the people who are performing are the people who own the overvalued things that are getting the flows from the indexes. You take the money out of value and put it in the index, they’re selling cheap stuff and they’re buying whatever the highest multiple, most overvalued things are in disproportionate weight,” [Einhorn] said.

Then the active managers participating in that part of the market get flows and they buy even more of the overvalued assets.

As a result, stocks, rather than “reverting toward value” instead “diverge from value,” Einhorn said. “That’s a change in the market and its a structure that means almost the best way to get your stock to go up is to start by being overvalued.”

Personally I don’t believe complex, adaptive systems like markets get ‘broken’. Rather, I suspect if there’s a reckoning due then it’s merely been postponed.

But Einhorn is smart and time will tell.

Stay on target

In the meantime Einhorn says he’s looking to those running his cheap and unloved companies to return capital to shareholders via buybacks and dividends.

Which doesn’t sound too new-fangled to me. But it is more honest a mission tweak than changing your benchmark when you’re lagging, so one and half cheers from me.

Also, Einhorn might take heart from the conclusion of GMO’s letter. The wonks argue that active investors have taken their pain, and sooner or later they’ll enjoy the gain:

Time will tell if the Magnificent Seven turn out to be as fallible as the Nifty Fifty or the TMT darlings that preceded them at other notable times of mega cap outperformance, but the history of mega caps when they are trading at a substantial premium to the rest of the market is particularly poor.

If the U.S. equity market becomes less concentrated – our bet for the next decade – skilled active managers are poised to have a decade for the books.

Allocators who stick to basics, reminding themselves of the virtues of diversification, stand to benefit handsomely.

That would be nice, wouldn’t it?

Maybe next year…

Have a great weekend.

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What caught my eye this week.

Seems that even Vanguard investors can be turned into – ahem – ‘tactical asset allocators’ if they are hit by one of the worst bond slumps for several generations.

Trustnet reports that in 2023:

[…] investors withdrew £426.2m out of Vanguard LifeStrategy 60% Equity, the largest fund in the [LifeStrategy] range.

Yet, Vanguard LifeStrategy 40% Equity was the most affected fund, as it shed £1.2bn, making it the most sold portfolio in the IA Mixed Investment 20-60% Shares sector.

Investors also shunned Vanguard LifeStrategy 20% Equity, taking out £404.6m from the smallest fund in the LifeStrategy range. As a result of those outflows, it was the most sold fund in the  IA Mixed Investment 0-35% Shares sector.

These are not inconsequential liquidations.

In the case of the LifeStrategy 20% Equity fund, it represents about a 25% outflow versus that fund’s size the year before.

Everybody hurts

While I believe that many of those taking money out of these funds are probably making a mistake, I do sympathise.

As I wrote when recapping the calamitous bond crash of 2022, the whole reason we own bonds is to (hopefully) make our portfolios less volatile.

Equities are where you go for thrills and spills. But bonds are meant to numb you into ignoring most of that action.

Great in theory, but at the time I posted that piece (late November 2022), the supposedly most-boring LifeStrategy 20% Equity fund had actually delivered the biggest one-year loss of all the LifeStrategy line-up.

That was not the game investors thought they were playing. So it’s not too shocking some have said “thanks but no thanks” and taken their marbles elsewhere.

Yet as both myself, The Accumulator, and many others have belaboured since the bond crash, that was then and this is now.

The sell-off in bonds made their yields reasonable again. That is key. It doesn’t rule out another bad year for bonds, but overall their expected returns over the medium-term are now much higher.

You may remember Vanguard itself gave us a forecast just before Christmas?

The fund titan said:

We expect UK bonds to deliver annualised returns of around 4.4%-5.4% over the next decade […]

That’s a huge difference compared to when quantitative tightening started in early 2022.

Indeed Vanguard was looking for just 0.8%-1.8% 10-year annualised returns as recently as the end of 2021, just before the rate-hiking cycle began

Sweetness follows

The ultra-low yields that prevailed for over a decade presented huge challenges for everyday investors – and for those who write about such things, too.

With hindsight, everyone would have liked to have sold bonds before they… repriced.

If only life were so simple.

Nevertheless, even before the sell-off somebody who was in the LifeStrategy 20% Equity fund probably didn’t have much capacity or tolerance for losses.

That was presumably why they were in that fund in the first place. And it wasn’t necessarily the wrong place for them to be.

Dreadful though a 10%-plus loss from a bond-heavy fund in a year might feel, that’s much less bad than the worst you’ll see from equities.

In fact a 15% down market is routine from shares every few years. (Try on a 30-50% crash for size.)

Shiny happy people

Presumably much of the money withdrawn from bond funds has gone into cash. That’s not the end of the world while interest rates are healthy.

A chunky holding of cash might not even be a bad long-term decision for some investors – though that money will likely underperform bonds if it stays in cash for long enough.

But if what was meant to be low-risk bond money held by low-risk investors has actually shifted into equities? That’s an accident waiting to happen.

We’ll have to wait and see. (And thus discover once again what only looks obvious with the benefit of hindsight.)

• Want more? Learn why a diversified portfolio needs more than bonds.

Have a great weekend all. Hope your side does okay in the Six Nations, which has just kicked off. But better yet that my side wins!

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