A great deal of attention is focused on growing tech companies like the “FAANG” stocks. Obviously, businesses can generate great returns just by growing in size. More income leads to a higher stock price. In times like these, it’s tempting to think that building a huge market cap is the only successful business strategy. But it’s worth remembering there’s another source of shareholder return.
Fund Flows vs. Stock Flows
With equity funds and ETFs, inflows generally cause a rise in stock prices. When investors pour cash into funds, the fund managers must put that cash to work by buying stocks. The resulting increase in demand causes stock prices to rise. Inflows are a good thing, outflows are bad. Simple concept, right?
But inflows into equity funds do not mean there are inflows into stocks. When an equity fund buys a stock on the open market, cash is exchanged with the seller. Unless there are newly-issued shares, there is no net inflow to the business.
Take a look at the below chart from Bloomberg. It shows that the biggest buyers of stocks recently have been corporations making repurchases:
Like inflows into equity funds, buybacks usually cause stock prices to rise. At first glance, one might think all these buybacks represent a cash inflow. Like an investor buying shares of a mutual fund, aren’t buybacks just inflows into the stock?
Actually, no. A company uses cash to purchase its stock from other holders. Those holders receive cash, and the company effectively “retires” the shares from the public market. With a buyback, cash comes out of the company’s balance sheet and into the hands of investors. Buybacks are cash outflows from a stock.
People sometimes assume a rising price means money is flowing into a stock, and a falling price means money is flowing out. But every trade has a buyer and a seller. The price movements of a stock do not represent flows into or out of the business. The stock market can continue to rise while cash is flowing out.
And for shareholders, well-timed cash outflows can be very, very good. Some of the most consistent, highest-performing stocks in the last century have delivered returns through cash outflows. Take a look at this chart of Altria’s stock price (white) and its shares outstanding (green):
From March 1990 to today, billions of dollars in cash flowed out of the company. Altria paid consistent, rising dividends, and simultaneously reduced its share count by 32% through repurchases. The market cap grew by 243%, but the total return for investors was 9,095%. By comparison, the S&P 500 returned 1,161% over that time.
This is not an endorsement of Altria’s products (tobacco) or its stock going forward. But it’s worth remembering that growing a huge market cap, as the FAANG stocks have done, is not the only way to produce gaudy shareholder returns. Sometimes companies just know when to push cash in your pocket.
The surging price of bitcoin grabs a lot of attention. But it also raises questions about the nature of money and currency. What gives a currency its value?
The Elements of Money and Currency
Money is a medium of exchange. In a way, money is fiction; everything depends on people believing in its value. If enough people agree, anything can potentially be used as money—people have been known to use seashells, salt, grain, and even giant stone disks. Each of these options have drawbacks, of course. Seashells can weather and break. Grain can rot. Giant stone disks are hard to tote around in your pocket. Coins and paper money help solve these problems.
Currency is any widely-circulating form of money. The dollar, pound, and yen are state currencies. Gold is often considered a currency. Bitcoin, ripple, ethereum, and other alt-coins could also be considered currencies. You can exchange modern currencies in physical form, as you do with cash, or in electronic form, via credit cards, payment apps, or cryptocurrencies.
But what constitutes a useful currency? What attributes do we want for the currency we use every day? First and foremost, you need general acceptance. People must agree to accept the currency as payment. This agreement can come through legal means (when the government declares it legal tender), or through organic means (when people decide on their own, like with bitcoin).
Second, you want price stability. You need a reasonable sense of what your money will buy tomorrow, next month, and next year.
If you have hyperinflation, you have no faith in your currency’s purchasing power. Your incentive is to spend or exchange your currency as fast as possible. Many emerging countries (Yugoslavia, North Korea, Zimbabwe) have experienced currency hyperinflation.
If you have deflation, everyone’s incentive is to hoard the currency. If there is no incentive to spend or invest, economic growth stalls. Along with the Great Depression, the United States saw several deflationary periods in the 19th century such as the panics of 1837 and 1873.
A Real-World Experiment
I recall an interesting story that helps illustrate the difference between useful and ineffective currencies. The podcast Planet Money did an episode called Libertarian Summer Camp about a festival for government skeptics. For a few days, festival-goers were completely self-sufficient—they sold food and beer without licenses, traded goods, and discussed abolishing the IRS. They also engaged in a small-scale economic experiment, conducting daily business using silver and gold instead of the U.S. dollar.
It was clear that as everyday currencies, precious metals have some drawbacks. First, it’s hard to pay in small increments. If you want an omelet for breakfast, you need to measure out little shavings of silver. You need to carry around a scale, and unless you trust everyone you’re doing business with, you may have to test each bit of metal for purity. Paper money and electronic payments like credit cards and cryptocurrencies solve this physical problem.
But there’s another big drawback—the prices are volatile. This month, an omelet might cost 0.22oz of silver, but next month, it could be 30% more. Today it’s one price, but tomorrow, who knows? So how did the libertarians solve the volatility problem? They used their smartphones to look up the price of silver (in dollars, of course).
This is a silly anecdote, but the point is that price stability is extremely important for a useful currency. Because precious metals don’t have price stability, people need a stable reference currency (like USD) to decide what to pay. Not knowing what your money will buy tomorrow is not a good quality in a currency.
Mechanism for Price Stability
For decades, the U.S. dollar has exhibited strong price stability compared to other currencies. If you hold dollars, you aren’t worried about day-to-day volatility in your purchasing power. If you save money for a car, you have faith you’ll be able to afford it when it comes time to buy. You aren’t worried the car will cost $15,000 today, $20,000 tomorrow, and $5,000 a few weeks later.
The dollar’s price stability is aided by the central bank through monetary policy. To combat inflation, the Fed decreases the money supply. To combat deflation, the Fed increases it.
With gold, silver, and bitcoin, there is no central bank. If you distrust the government, the lack of a central bank may be a selling-point. But it doesn’t do much for price stability. If you own ten bitcoins or a pound of gold, what can you expect to buy with them next year? What about tomorrow? The lack of a mechanism for price stability is a major disadvantage. Without price stability, gold and Bitcoin are not effective as modern currencies.
Bitcoin and Source of Value
Bitcoin has no intrinsic value. You can’t eat it, use it to build things, or even look at it. It’s a virtual currency that exists in a virtual space—a decentralized ledger called blockchain. Its price is determined entirely by the market, and there is no government or central bank that can influence it. If people want to exchange bitcoin for $10 each, they can. If they exchange it for $1M each, so be it.
Blockchain, the distributed database bitcoin uses, is a useful payment system. It is anonymous, secure, and fast. To use blockchain for payments, you can convert dollars to bitcoin. The seller can instantly convert it back. Payment companies like Coinbase and Stripe already do this. There is no need to hold the bitcoin for more than a few seconds, so you can avoid the volatility risk.
Many people confuse bitcoin (the currency) with blockchain (the database). Because blockchain is a great payment system, people say, bitcoin must be valuable. But what imbues bitcoin with a specific value? Why should we assume $10, $100, or $1M is “correct”?
Some people claim it’s supply and demand—because bitcoin has a finite supply, the price of bitcoin will simply increase with demand. But if we can use bitcoin for payments without holding it for more than an instant, where is the stable source of demand? Demand comes from people wanting to hold bitcoin, not just use it for payments.
Another concern is the growing number of “altcoins.” Here is a list of the top 100 cryptocurrencies, by market cap. The higher the market price of bitcoin goes, the greater the incentive to create and trade alternatives.
Why Hold Bitcoin Long Term?
For months, I’ve been asking cryptocurrency fans for answers to this question. What are the benefits of holding bitcoin, besides speculation? I hear plenty of good reasons for the merits of blockchain, but never the merits of bitcoin as a currency. As far as I can tell, the only reason to hold bitcoin for any length of time is the belief that its price will rise.
This is absolutely fine, if you want to speculate. If you think bitcoin will trade for $1M in five years, it might make sense to own some. But I wouldn’t bet the farm. It’s an asset with no intrinsic value, no physical form, and no mechanism for price stability. Blockchain gets well-deserved hype, but this does not mean Bitcoin has any predictable value. Maybe bitcoin will trade for $1M someday, but not for any reason other than human behavior.
My inspiration for writing this piece was a concerning post last week from someone I’ve known a long time:
This is part two in a series on active management. For part one, click here.
A few years ago, a friend asked my advice about an IRA. Her financial advisor had chosen the investments while she was in high school.
When I looked at the statement, I was appalled. The advisor had picked two variable annuities—a long/short fund and market neutral fund—both completely inappropriate for someone with a long time horizon. My back-of-the-envelope math showed these annuities had cost her more than 100% in gains, or about $15,000, compared to a S&P 500 index fund from Vanguard or Fidelity.
How does this kind of thing happen? Simple: the advisor was paid a commission. He received a fee for putting her in products which themselves charged high fees. He had little incentive to do the right thing for his client, and every incentive to choose a product that would earn him a fee.
Unfortunately, that’s why many overpriced products still exist. Commissions-based financial advisors and cheaply designed 401(k) plans routinely put unwitting investors into products that charge outrageous fees. If we didn’t have a system that encourages these products, they simply wouldn’t exist. They would be competed out of existence by superior, cheaper alternatives.
Meb Faber has an excellent post about certain index funds that charge inexplicably high fees. One example, the Rydex S&P 500 Fund C Shares (RYSYX), has an expense ratio of 2.31% and the gall to charge a 1% exit fee on top of that. By comparison, the equivalent fund from Vanguard (VFINX) charges 0.14%. The chart below shows the performance of this fund against the S&P 500 since its inception.
From its inception in 2006 until April 2017, the Rydex fund has underperformed its index by a cumulative 51%, and that’s before the 1% exit fee. Imagine what that would do to your retirement fund over time.
As outrageous as these fees are, it gets worse in many active funds. First, take the Sparrow Growth Fund (SGFFX). It’s an equity fund with an expense ratio of 2.45%, a 5.75% front load (entry fee), and a 1.00% back load (exit fee). If you buy this fund, you’re signing up for over 8% in fees even if you only hold it for a year.
There’s also the Saratoga Technology & Communications Portfolio (STPAX). It has an expense ratio of 2.24%, a 5.75% front load, and a 2.00% early withdrawal fee. If an advisor bought this for you, you may not be happy about the 7.99% in fees you’ll pay in the first year. If you want to sell, no worries, just pay an additional 2.00%.
If you were a fan of the technology sector, you could have instead purchased a NASDAQ 100 index fund like QQQ, which charges 0.20% and no load. The below chart shows the performance of these two funds since QQQ’s inception date, and doesn’t even account for the 5.75% front load.
This underperformance is not just due to bad stock picking: the active fund would be much more competitive if not for its high expense ratio.
What about those painful front-end load fees? Consider a hypothetical fund that outperforms the S&P 500 by 0.50% every year, but charges a 5% entry fee. The chart below illustrates your dollar underperformance if you invested $100,000 in this hypothetical fund:
If you bought the fund at the end of the year 2000, it would take more than ten years for that 50 basis points per year of outperformance to “catch up” to the 5% fee you paid initially. This also assumes you picked a fund that can consistently outperform after management fees, which is a serious hurdle.
Fighting off the Zombies
Many hyper-priced funds are small, but they still survive. The way some funds stay open is by obtaining investors through unusual means. Maybe a financial advisor gets paid a sales commission or a poorly structured retirement plan offers the fund as a 401(k) option. Maybe someone buys the fund, pays the high entry fee, and feels mentally “invested.” This is the sunk cost fallacy in action.
There are still some excellent active funds with reasonable fees, but many funds remain on the market when they shouldn’t. Fund companies know that high fees are a drag on performance, and it’s easy to see how funds fail to outperform their benchmarks if they charge fees of 1%, 2%, or above. They’re like the living dead; they limp along, dragging down the healthy in the process.
Common knowledge in investment circles is that drawdowns are bad. But are they always bad? Are there times when they’re especially bad?
Let’s explore these questions by looking at stocks and bonds. From 2001-2016, the S&P 500 returned +133% and the Barclays US Agg. Bond Index returned +112%. In this time period, the cumulative returns of stocks and bonds were fairly close, but the return patterns were very different.
The chart below shows the growth of a $100,000 investment in these two indices. As you can see, stocks had significant drawdowns during the period while bonds were less volatile. If you simply bought and held for the 16-year period, you would receive a +133% return in stocks and +112% return in bonds. Your account balance would have ended about 10% higher investing in stocks than bonds.
The next chart shows the same initial investment of $100,000, but this time let’s assume you deposit/buy an additional $500 per month. You will notice that under this scenario, stocks worked a little bit better—your ending balance would have been 25% higher investing in stocks than bonds.
The third chart shows the same initial investment of $100,000, but let’s assume you sell/withdraw $500 per month. You will notice that under this scenario, bonds did much, much better—your ending balance would have been 154% higher investing in bonds than stocks.
The three scenarios above illustrate the drastically different outcomes that are possible when investing in the same two indices. The only difference between each scenario is the assumption that you made deposits or withdrawals along the way.
What it means:
The three scenarios above demonstrate the importance of drawdowns depending on your situation.
1) If you make no trades, the return pattern doesn’t matter—the only thing that matters is your return. Of course, this is not how most people invest.
2) If you’re depositing on a regular basis (e.g., a young person with a 401(k)), big stock market drawdowns shouldn’t scare you. In fact, drawdowns help you, because they allow you to buy more shares at a lower price.
3) If you’re withdrawing on a regular basis (e.g., a retiree), drawdowns matter a lot. If you sell during a drawdown, you have to sell a larger quantity of shares to get the same dollar proceeds.
This is not a comment on the behavioral effects of volatility. These scenarios assume you can stick to a regular plan.
The above simply demonstrates how much return patterns matter depending on the investor’s situation. Drawdowns are not always bad, and can be beneficial to someone with a long time horizon who is dollar-cost averaging. But drawdowns are absolute killers if you’re making regular withdrawals.
Postscript (Into the Weeds)
I often see discussions of the negative effects of volatility. For example, this Michael Batnick post makes the valuable point that “outsized volatility is a drag on returns.” It shows how a portfolio can erode over time if it experiences alternating gains and losses.
The below chart shows what happens over time to a dollar if it experiences alternating gains and losses of +10%/-10%, and +20%/-20%:
But here’s the thing: volatility is not what causes the value to drop. The reason is that a gain of 10% is not equivalent to a loss of 10%.
If you lose 20%, you need a 25% return to get back to zero. So -20% is equivalent to +25%.
To find the equivalent loss for a gain of 10%, we can use the formula 1/(1+r)-1, which in this case is about -9.09%. This is because single-period returns are compounding, not additive.
In other words, a single-period return of 10% is actually equivalent to a loss of 9.09%. You could alternate returns of +10% and -9.09% forever and never fall below your original dollar.
A portfolio can experience equivalent gains and losses forever, but the trick here is that +10% is not equivalent to -10%, and +20% is not equivalent to -20%.
After reading Michael Batnick’s excellent posts about the distribution of stock market returns (read The Skew and The Other Side), I was inspired to look back at the market of 2015.
Perhaps you’ve heard about 2015, the fabled year when the four “FANG” stocks (Facebook, Amazon, Netflix, and Google) accounted for all of the gains (!) of the S&P 500. Many articles and blog posts were written about this phenomenon in 2015, and the “FANG year” became something of a meme in financial discourse. The S&P 500 returned only +1.4%, but the four FANG stocks returned +34%, +118%, +134%, and +46%, respectively. They accounted for the all of the gains (!) of the S&P. Crazy, right?
Will Deener of the Dallas Morning Newswrote, “One of the hallmarks of a healthy bull market is that a broad swath of stocks and sectors move higher in tandem. Currently, that is not the case, with both the S&P 500 and Nasdaq being propped up by only four stocks.”
Only four stocks!
Many people surmised that investors who missed out on the FANG stocks must have had a dismal year. If you picked a random stock from the S&P 500, you would almost certainly not pick a FANG stock, so you must have had a terrible year, right?
Let’s look at the numbers. If you had thrown darts at a board to pick one random stock out of the S&P 500 and held it for the entire year, what were your chances of picking one that outperformed the index?
Yes, 47% of stocks in the S&P 500 outperformed the index that year. So slightly less than half. But still, almost half. You would have had a 47% chance to outperform the S&P 500 just by picking any stock at random and holding it for the year.
What were your chances of selecting a stock that had a positive return?
50.37%. You would have had better-than-even odds of a positive return by picking any stock at random that year.
Let’s look at the distribution of returns in the S&P 500 in a histogram:
The above chart shows the number of stocks that had a 2015 total return at various minimum ranges. The best performing stock (Netflix) returned +134.38%, and the worst (Chesapeake Energy) returned -76.76%. How did the rest do?
50% of stocks returned at least +0.13%.
40% of stocks returned at least +3.83%.
30% of stocks returned at least +10.09%.
So in the infamous “FANG year,” when supposedly all of the gains (!) in the S&P 500 went to just four stocks, 30% of stocks in the index actually returned over +10%.
So what’s going on here? Why was this meme so misleading?
The S&P 500 is market cap-weighted (companies are weighted by their market value). A stock’s weight times its return equals its contribution. Bigger companies have a larger weight, so they can have a larger impact on the index’s return. In 2015, some of the best-performing stocks also happened to have some of the heaviest weights in the index. So it’s true that if you owned the S&P 500 index except for those four stocks, your +1.4% gain would be gone. These four stocks had a combined contribution of almost +2%.
In any given year, the index includes positive contributors and negative contributors. If you took all the stocks with gains in 2015, their combined contribution was +8.9%. This is the gross contribution, or what most people would consider all of the gains. If you took all of the stocks with losses, their combined contribution was -7.4%. This is all of the losses.
When you put the gains and losses together, it was a fairly flat year for the market. The net of all gains in the S&P 500 was just +1.4%. But wait, commentators said, the contribution of the four FANG stocks was more than +1.4%. So voilà, just those four stocks accounted for all of the gains (!).
Naturally, when gains and losses net close to zero it becomes easy to pick out a small group of stocks whose contributions add up to the net market return. What’s more, the FANG stocks weren’t even the top four contributors that year. Amazon was number one, but Microsoft was number two and G.E. was number four. Saying only the FANG stocks mattered in 2015 is like saying the only reason a football team won 28-21 is one particular touchdown. Every point counts.
All this FANG talk gave many people the false impression that only four stocks had any gains at all that year. But there were plenty of other stocks with huge returns that year. NVIDIA returned +67%. Hormel foods returned +54%. Starbucks returned +48%. Kroger returned +32%.
Nevertheless, the “FANG year” meme had spread across financial media like World War Z. It’s a fun idea, but not all that meaningful.