Technology Stocks – The Truth Some Active Managers Try to Hide
Date Published: 1 August 2018
Index investing has grown enormously as the public becomes increasingly aware that most active funds simply do not deliver over time, and that paying less in fees and charges tends to produce higher returns over the long term. In desperation, the endangered dinosaur traditional fund managers have resorted to fake news to try and arrest the growth of smart modern common-sense investing.
One of the greatest myths is that index funds must be buying stocks in large companies that have gone up the most and therefore will be the most expensive ones. The fact is that the largest stocks are not necessarily the most expensive stocks, it depends on their valuation not their size. Say a large company grows its profits by 3x over 5 years during which its share price doubles. Are the shares more expensive? Arguably not, as the share price in this example has not kept up with the growth in profits. Of course, the valuation of a stock is based more on profits alone, but it is totally ignorant to say that because a share price has gone up, the stock must be more expensive.
Then there is the myth that the active manager will justify its extra costs by being in cash before the next great market fall and that the active manager will have avoided these overpriced stocks through careful selection.
Here is one example from the Head of Fund Research at Investec “Active investment managers also understand that the best way to protect and enhance returns is to adapt to changes in the market. Unlike passive investments, which are tied to an index, active investment managers – and their investors – aim to predict trends and have the flexibility to switch strategy in an instant if the markets take a turn for the worst.”
This is complete nonsense as:
1. There is no evidence that active managers are successful at “protecting and enhancing returns” to changes in the market or are successful at switching “strategy in an instant if the markets take a turn for the worst.”
If that were the case, the last time world markets collapsed, the active managers would have predicted this great change and run to cash or more defensive stocks. They didn’t.
This is what happened in 2008 to the average UK mutual fund compared to the market (FTSE All-Share Index) and the average US fund compared to the market (the S&P 500 Index)
Furthermore, it is pure bunkum to think that it is easier to trade the stocks within an active fund than an index fund which will normally have greater liquidity, especially during times of stress. The typical index fund will tend to be concentrated on larger stocks which normally have much greater liquidity. Often after market collapses, various active funds holding smaller or less liquid stocks are forced to suspend their funds or limit withdrawals. This does not happen in index funds.
2. It is also untrue that managers utilising index funds are somehow “tied to an index”. Active Exchange Traded Fund (ETF) managers like us at SCM Direct, who only invest via index funds have a choice – which regions? which countries? which types of stocks e.g. small or large cap? or value or growth stocks? even which sectors? Therefore, we can adapt to changes in the market e.g. buy more emerging market stocks, or smaller cap, or more tech or anything else come to that. There are thousands of different index funds and we are fortunate to be in a huge growth market in terms of ETF funds so have an increasing pool to choose from. Those passive managers who always buy the simplest index fund in the largest market (the US) without considering the alternative are just being lazy.
In terms of technology stocks, let’s take Facebook, Twitter and Netflix which all reported last week. This is their recent performance following results last week which led to sharp downward revisions in its forecasts:
Facebook ($485 Bn market cap as at 30th July 2018)
Source: Bloomberg LP
Facebook fell by 20% after its results showed slowing numbers and it forecast much lower margins, resulting in forecasts for 2019 and 2020 earnings falling by c. 10%.
Twitter ($24 Bn market cap as at 30th July 2018)
Source: Bloomberg LP
Twitter shares fell 20% after its recent results showed user numbers falling to 335m from 336m in the previous quarter.
Netflix ($148 Bn market cap as at 30th July 2018)Source: Bloomberg LP
Netflix 2nd quarter subscribers missed forecasts leading to a fall in its share price. Netflix has 130m subscribers but hitherto has not made any money from its subscribers due to the cost of TV content skyrocketing. The average price of dramas doubled to about $5m an episode over the last two to three years (many of Netflix’s top shows cost $5 to $10m per episode).
At SCM Direct, we have 15% of the Long-Term GBP portfolio invested in US stocks but not via simply holding the conventional S&P 500 index, which is dominated by these expensive technology stocks. We invest in US equities via various indexes that focus on stocks that appear cheap on their fundamentals e.g. book value, sales, cash flow, dividends etc rather than solely their size alone. Sometimes these stocks may be technology stocks but only where their valuation is supported by their fundamentals. US semiconductor, IT software, IT hardware and IT services stocks accounting for a combined 25.6% of the S&P 500 Index (the main US equities index) but just 2.3% of the equities part of the SCM Long-Term Return GBP Portfolio.
|% of MSCI World Equities Index||% of SCM Long-Term Return Portfolio GBP|
Interestingly these “value” stocks which have been underperforming for a substantial amount of time, are now moving back into vogue, particularly against the technology stocks:
So contrary to the fake news being spread by traditional active managers, modern active managers such as SCM can be “active” and make decisions using index funds.
Sadly, many managers offering index fund portfolios are missing the biggest opportunities by just investing in plain vanilla indexes. Of course, there are times when these will be the most efficient and most attractive way to invest in a market but not always.
You don’t have to use over-charging, overly concentrated active funds to be active, in my view it is far more efficient – both in terms of cost and risk – including liquidity, and effective – in terms of returns, to be active using modern ETF index funds. Still, it will be a long time until the dinosaurs of traditional active management spot this.
Read more blogs by Alan Miller here
The value of investments can go down in value as well as up, so you could get back less than you invest. Exchange rates may cause the value of overseas investments and income from them to rise and fall. It is therefore important that you understand the past performance is not a guide to future returns. SCM Direct does not give personal advice.
SCM Direct is a trading name of SCM Private LLP which is authorised and regulated by the Financial Conduct Authority to conduct investment business. Company registered in England and Wales, no. OC342778.