We are all familiar with the famous investment market phrase “in the short run, the market is a voting machine but in the long run, it is a weighing machine”.
Some may know that this is attributed to Benjamin Graham, the British-born US investor, economist and professor recognised as the “father of value investing”. Fewer will be aware that he worked with and advised the future manager of Berkshire Hathaway, one Warren Buffett, who considered him to be his guiding influence on his approach to investing.
It was therefore surprising to read recently that Buffett considers the founder of Vanguard, Jack Bogle, one of the pioneers of passive investing, to be a hero for protecting millions of investors from the high costs associated with active management. This struck me as odd coming from one of the most successful active investors ever.
However, there is a commercial angle tied up in this – which is a relief, because if the “Sage of Omaha” is turning passive then we surely are all doomed.
Betting on himself
Buffett made a $1m bet (for charity) with a hedge fund in 2008 that a particular Vanguard index fund would outperform a selection of five fund of hedge funds over 10 years. Since then, the Vanguard fund is up 65.7 per cent while the hedge fund of funds is up just 21.9 per cent with less than two years to go.
So has Buffett sold out? My cynical side led me to check his investments in his main Berkshire Hathaway investment fund for Vanguard interests but there are none, and Vanguard is not a quoted company, being mutually owned by its investors.
The only conclusion I could draw was that it is in his interests to rubbish much of the rest of the active management industry to highlight his own expertise. I have looked at the performance of his own fund relative to the S&P 500 and, sure enough, he is comfortably ahead.
My conclusion is not that Buffett believes index funds are the only way ahead, but that we have yet more confirmation that there are a lot of poor active managers out there, marketing their supposed expertise in clever ways and making a very good living off the back of it.
And therein lies the point. All active fund managers must have high degrees of self-belief and it is up to we investment advisers who select investments for clients to sort the wheat from the chaff in pursuit of outperformance.
Why is this relevant now?
Returning to Graham’s quote, the more user-friendly interpretation of it is that longer-term returns are driven by valuations but investor risk appetite drives shorter-term returns. It is the latter that has driven the equity markets to their current levels, with a dose of greed and animal instincts added in.
I posed myself a difficult question recently based on the fact that we are seeing some clients stepping back from the markets, either taking profits and holding excess cash or new clients wanting to phase fresh investment in the hope that a correction will present itself from which they can take advantage. If I were forced to invest the entirety of a client’s funds today without any cash, what would I buy in the knowledge that there is a clamour of would-be buyers out there wishing for a correction?
This is classic bull market mentality and can persist for some time as reticent investors on the side-lines become intolerant of underperformance, gradually capitulate and throw caution to the wind and buy at any price. We are not yet at that stage but there is a lot of cash out there which will make any correction short-lived if it arrives. The potential upside could be painful relative to cash.
There is good reason to doubt the market rally. Trump’s raison d’etre is economic growth, jobs, tax cuts and infrastructure spending, and he has little else to fall back on if he fails to deliver on any of these. The likelihood of disappointment has to be high based on historical precedent.
So, returning to my own challenging question and extrapolating Graham, it would be unwise to buy anything that has been bid up on recent investor appetite and we should instead focus on those areas where investor appetite is low. It’s a classic contrarian value approach and we have been doing just this in our own asset allocation decisions.
Areas with low investor appetite where we are overweight are commercial property, emerging market equities, European equities, Brexit-affected UK domestic sectors, US Treasuries and Asia-Pacific equities. So, if I were forced to invest today, it would be a combination of these areas – but note the absence of US equities and large-cap UK equities where 75 per cent of the earnings have risen on sterling weakness and not true organic earnings growth.
There are always assets to buy which will outperform the indices no matter how weak they may be. The current appetite for passive investing is ensuring that the large and most indebted (who have issued the most corporate debt) are attracting the most investment which is fuelling the rally as most indices are market capitalisation weighted.
Of course, there are some very good reasons why the aforementioned areas look relatively good value, but the expensive areas of the markets are priced for perfection and the cheap areas are priced for anticipated doom – adopting unemotional logic and parking greed and fear leads to favouring the latter. A strategy for the brave but one that Graham promoted and Buffett has followed for much of his esteemed investment career.