How's that for a sensational headline?
IndexUniverse has an article up that recaps 2007, it notes that fundamental indexing like the RAFI ETF (PRF) and some of the WisdomTree funds lagged the cap weighted funds. This was more of a domestic phenomenon than with foreign.
The article even quotes Bruce Lavine from WisdomTree offering some explanation. The article attributes the following quote to Lavine "There are some unique characteristics about the U.S. market that have just been tough this year. That had to do with getting let down by companies that had solid fundamentals on paper."
The article concludes that it does not really mean much as it is just one year and the author posits that subprime could be to blame.
I don't think the article looks at quite the right thing and I would say there is not enough of a look forward.
Most of what happened with domestic fundamental indexing can be explained with a this-is-how-the-market-works analysis. If you read any of my TSCM articles (here's one from August, 2006) about any of the broad based WisdomTree funds you will probably find a word of caution because they are heavy in financials and with the curve flattening/inverting (depending on when the article was written) the funds could have problems.
That's right, yield curve, it all reverts to the yield curve. Fundamentally weighted funds tilt to value. Value lags growth with a flat or inverted curve because debt offerings (the manner in which more mature value companies access capital) are not as easy to price and value companies can't issue stock as easily as growth companies because it is too dilutive.
Growth also beat value in the late 1990's and the curve was flat on the way to an inversion back then. This is just how capital tends to flow and during periods of steep curves value leads. This is how the market works, or has worked anyway.
Subprime is a little too narrow of an explanation. The inverted curve created a poor environment for financial stocks which hurt the fundamental products, especially where WisdomTree was concerned.
In terms of looking forward, blaming subprime isn't quite right because it will never happen again. Now is the subprime event, there won't be another (here I am not saying how long it will take subprime to work itself out and be over) but there will be future yield curve inversions and when it happens again growth will beat value and fundamentally weighted products will very likely lag cap weighted.
This fact should not make fundamentally weighted any more or less attractive. If value continues to outperform growth as it usually does over long periods of time then it makes sense to think fundamentally weighted funds that are properly constructed should outperform cap weighted indexes, future lags when the curve inverts notwithstanding.
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14 comments:
Roger,
At the start of 2007, many voices expressed worry over an inverted yield curve; just as many others claimed that, as a market signal, the yield curve was passé because other economic forces are now at work. It seems that ye olde curve just took a while longer to work its way into our pockets.
You wrote about Ben Stein in your Monday post. Here is a view claiming that he has rendered himself irrelevant.
http://tiny.cc/bZux1
i spent quite a while last night reading the various posts the Barry linked to plus a couple others i found that dumped on Stein.
I disagreed with this latest one from Stein but chose not to really explore that aspect of it.
Also, the Rydex Equal Weight (RSP)was essentially flat on the year, while paying out just $0.62 (1%). I thought the writing was on the wall in the summer of '07 about the challenging environment ahead for the smaller caps.
Roger, interesting point about the yield curve dictating how certain segments might perform. Do you adjust your weighting on a value/growth measurement in this case? I know an inverted yield curve to you is a red alert to expect downside and volatility, right?
i do change style tilts with this, NKE a year ago and MON a few months ago as examples.
inverted curve is a harbinger even if the timing aspect is not so great. this go around it took longer to matter than in the past.
Roger,
I would go a little further and point out that the market always goes through periods where "things are not as they should be." In each instance, the imbalance takes on a different form, so people don't notice it until it's too late. In the 2000 stock market people were ignoring P/E ratios. In the housing bubble people incorrectly assumed (among other things) that home prices would go up forever. Now people are ignoring the historically low dividend yield of the S&P 500 index (2% or lower for several years).
Companies with extra cash (typically value/dividend-paying companies) have been buying back their shares instead of paying dividends. This deprived long-term investors of income, and temporarily inflates prices. The negative consequences finally began to appear in the summer of 2007, when *all* value and dividend funds began to lag the rest of the market. Nine times out of ten, when a large group of focussed investments appears, (fundamental or dividend-paying ETFs) it means the bubble has topped out. That was the case this time as well.
Jody I don't draw the same conclusion as you. assuming your facts are correct about buybacks versus divs (i don't know if they are) I would view that as more of a byproduct and not a cause.
You mean the black boxes were wrong? Never would of guessed that. Computers that pick stocks surely are superior to humans and know in advance when a company is only financially strong on paper?
That article does what articles of that type often do: make me research more. Especially now that there are other international small cap index funds that I could use instead of the Wisdomtree option.
after several weeks without a short position it is time to ease back into the short positions.
i am taking the other side of Cramer's trade. I started to short retailers today with a small position. Looking to build on that and re-enter SRS in the next week.
--Sami
Very interesting about the yield curve correlating with growth vs. value.
As for the equal capitalization funds underperforming capitalization weighted funds: Small caps underperformed large caps last year (Look at the Russel 2000 vs. the S&P 500) so it makes sense to me that a fund with balanced capitalization would underperform one heavily weighted toward large caps, as most index funds are.
Hi Roger,
Really enjoyed your post. Could you please clarify one point:
"Value lags growth with a flat or inverted curve because debt offerings (the manner in which more mature value companies access capital) are not as easy to price and value companies can't issue stock as easily as growth companies because it is too dilutive."
Based on my understanding, growth stocks have higher P/E since the growth is priced in, meaning that on a current basis, at least, they are giving up less earnings per dollar of equity offered. As for debt, what do you mean that it is "not as easy to price"? Wouldn't an inverted yield curve mean that a company can issue long-term debt for cheaper relative to short-term debt levels in comparison to when the yield curve is normal? Were you implying in any way that credit spreads tend to increase in terms of inverted yield curves? It just seems to me that when the yield curve is inverted, that means cost of debt will likely decrease soon, which benefits the value companies most of all.
Thanks for any light you can shed.
Roger-
I concur mightily with your opinion about the fundamentally weighted indexes. Value is overvalued here on an absolute basis and a relative one. It will struggle until that is redressed. And, as one reader pointed out, the equal weighted index was ripe for getting a smackdown as small caps cycled back. Nothing more than valuations on both fronts. This factor is particularly important in Bear Markets. Valuations of sectors start to matter A LOT. Beta and starting valuations are highly predictive during Bears of future returns.
MarkM
Mike,
if the curve is flat do you as an investor want to but long term bonds?
you probably don't and neither do most other folks, hence they are difficult to price.
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