The First to Present His Case

There is a proverb I like which states:

“The first to present his case seems right, till another comes forward and questions him.” *

The context of this proverb suggest it relates to court judgements but equally it is relevant to investment opinions as fund managers advocate polar opposite views on the investment case for differing assets and markets. For example many have called the end of a 35 year rally in bonds. Others disagree. It depends which hypothesis on the state of the global economy you subscribe to and the outlook for inflation and interest rates.

At all times but especially now after a strong rally in equities, opposing opinions on the direction of the global economy and stock markets need weighing up carefully. If you are investing cash now you run the risk of taking a big hit if there is an equity market sell-off. I have no evidence that a crash is coming but I would be surprised if there is not a sharp correction by the end of August. It could come from political events but I principally fear the wall of worry syndrome and the propensity for investors to act with a herd instinct in a crisis. I hope I am proved wrong.

When markets peak investors naturally seek to buy into undervalued sectors, invest into safe haven assets or those that are non-correlated to equities. The difficulty is identifying these and there is a danger in misreading the signals on markets that appear to be fully valued. Take US equities which have enjoyed one of their longest bull-runs in history. Two years ago I remember asset allocators were recommending rotating out of US equities to reinvest in the UK and Europe, based on valuations. The case for doing so was sound at first sight, US stocks were fully valued, prices were high and the bull market was long running, but others argued differently, challenging the consensus view. In a blog post from 2/9/14 I wrote:

“My last blog post focused on the US stock market and equity valuations. You will recall that opinion is strongly divided between the bulls and the bears. The latter have argued there is a disconnect between the high stock valuations and the lack of underlying earnings growth from US companies.

JP Morgan suggested the record high profitability for US companies is set to continue, domestic economic activity will drive revenue growth and the potential for taking on debt onto balance sheets will help counter headwinds such as higher labour costs and wage demands. They conclude although above average equity valuations will reduce expectations of future returns, the current analysis adds up to a constructive and benign environment for equity investment in the US. Time will tell.

Well the last two to three years proved JP Morgan was right. My instinct at the time was the US economy was innovative and strong and that equities would continue to rally and I therefore continued to recommend US funds to clients. I am glad I did. Today I am more selective about the US, favouring small companies and high yield bonds, but that is another story.

Index linked bonds are another divisive asset class, especially in the context of inflation and interest rate expectations. Inflation linked assets are the Marmite of the investment world. I happen to like them but time and space does not permit me to explain more. Instead the proverb cited I want to conclude on the case for global emerging market equities. There has been a wide, though not complete consensus from fund managers and asset allocators advocating emerging markets given the clear signs of an improving global economy, fears over the Chinese economy abating, rising commodity prices and attractive valuations compared to developed market equities. I pretty well bought into the story without too much questioning until along came counsel for the prosecution Terry Smith, a maverick fund manager who runs the iconic Fundsmith Equity fund. He is an one of the very best bottom up stock picking investors. In practice he ignores the speculation about the global economy, political events, currency movements and other macro-events on the basis that firstly they are very difficult to predict and secondly even if you can call them correctly what do you do about them? Instead his focus is purely on what he can control, picking strong companies and holding onto them.

In a recent article in the Financial Times Smith he included a graph of cumulative net inflows of investment into global emerging markets ETFs compared to non-ETF funds since 2000. To remind you ETFs are Exchange Traded Funds and these are tradeable securities that track a stock market index. They are examples of low cost passive investments that include all stocks (or a representative sample) held in a stock market index. The weighting of stocks is based on whatever criterion is used to compile the index, typically the market capitalisation of the companies. This means that as more money is invested via index funds or ETFs, it is automatically invested via the fund into the companies in the relevant index based solely upon their market value. Since 2000 just over $150 bn cumulatively went into emerging market ETFs. In contrast the flows into actively managed emerging market funds fell by $50 bn. The graph looks like a capital Y turned 90 degrees clockwise which Smith calls the “Jaws of Death.”

The implication of this is clear as Smith puts it himself:

If money pours into markets via ETFs it will cause the shares of the largest companies in the index to perform well irrespective of their quality or value — or lack of it.

In fact Smith states the largest companies in the emerging market index are not good quality based on a number of observations.

Another consequence of Smith’s view is that active fund managers picking stocks based on their underlying quality are likely to underperform passive ETFs and index tracking funds as long as inflows into passive investments continues. I conclude:

1. Caution is required when investing in global emerging market equities. Smith’s comments certainly have made me think I need to rein in my enthusiasm.

2. Relative outperformance of passive emerging market funds over actives should be treated with caution. Whilst it can be argued it is a no brainer to avoid actively managed funds when passives outperform and are cheaper, when there is a sell-off, ETFs are likely to suffer more with a reversal of the inflow benefit. For example if the share prices of the largest companies take the biggest hit because they are poor quality, it will feed through to poor index and ETF performance. I suppose the maxim advocated by Warren Buffet comes to mind:

“It is only when the tide goes out that you see who is swimming naked!”

3. It is best to avoid passives when allocating money to global emerging markets.

4. Actively managed smaller company funds should avoid the worst excesses of a collapse in emerging market equities as their weightings in ETFs will be small. You will know that I have an instinctive bias to smaller companies anyway.

*New International Version of Bible – Proverbs 18:17.

This blog post is my own investment thinking and commentary only. Nothing in this article should be construed as investment advice. Investment in US equities, US high yield bonds and index linked bonds may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.