So, Bill Ackman Makes Some Good Points on the Index Bubble…

10159650595_aea8898457_oHe’s often controversial… and usually pretty brash. But Pershing Square’s Bill Ackman is also usually quite insightful. He’s been at this game a long time, and he’s had his share of big wins… and big losses. Ackman has an ego on him. (What hedge fund manager doesn’t?) But he’s also his own biggest critics, and like all good investors he learns from his mistakes.

Today, let’s take a look at Ackman’s latest letter to investors, which came out last week. Ackman, like a lot of hedgies, had a terrible 2015. Here were some of his takeaways:

Not All Valuation Metrics are Equal

Ackman bet big on Valeant Pharmaceuticals (VRX)… and lost big when the stock rolled over. Per Ackman,

Principally, we missed the opportunity to trim or sell outright certain positions that approached our estimate of intrinsic value. Our biggest valuation error was assigning too much value to the so-called “platform value” in certain of our holdings. We believe that “platform value” is real, but, as we have been painfully reminded, it is a much more ephemeral form of value than pharmaceutical products, operating businesses, real estate, or other assets as it depends on access to low-cost capital, uniquely talented members of management, and the pricing environment for transactions. [Emphasis Sizemore]

Charles here. I learned a similar lesson in 2015. Just as Ackman lost money in an acquisition-hungry pharma stock, I lost money in MLPs, small-cap REITs and business development companies — three sectors that would normally have very little in common. But the tie that bound them was their dependence on the capital markets for fresh funding. When the credit markets got skittish, Mr. Market relentlessly punished these sectors, and two of my holdings — Kinder Morgan (KMI) and Teekay (TK) were forced to slash their dividends.

Know Who You’re In Bed With

Due to Ackman’s high profile, he tends to attract copycats. I myself have been guilty of perusing his SEC disclosures. This creates risks of its own:

Perhaps the largest correlation in our portfolio is one that we have not previously considered; that is, the fact that we own large stakes in each of these companies. We have had the benefit of a “following” of investors who track and own many of our holdings. This has given us significantly greater clout than is reflected by our percentage ownership of these companies, and we believe that it is partially what has caused the “pop” in market price when we announce a new active investment. As a result, these active managers’ performance is often closely tied with ours. When Valeant’s stock price collapsed, our performance, and that of Pershing Square followers, were dramatically affected. Nearly all of these investment managers are subject to daily, monthly, and quarterly redemptions, and therefore, many were likely forced to liquidate substantial portions of their holdings which overlap with our own…

While it is impossible to know for sure, we believe that our continued negative outperformance in the first few weeks of the year relates primarily to forced selling of our holdings by investors whose stakes overlap with our own.

This raises a bigger issue of simply considering who the major holders of your stocks are and what their constraints or motivations might be. Returning to my own losses last year, The selloff in MLP shares was massively exacerbated by mutual funds, ETFs and — most importantly — leveraged closed-end funds and hedge funds that were forced to liquidate to meet redemptions or margin calls. This were holders that were forced to sell at whatever price the market gave them.

The Index Fund Bubble… And What It Means

Finally, Bill Ackman has some insightful comments about the “bubble” in indexing. Given the lousy performance of active managers over the past decade, it’s easy to see why investors continue to flock to index funds. They are cheaper in terms of fees, more tax efficient and have had better returns of late.

But here’s the problem. Indexing only works when their are a sufficient number of active managers to make the market at least semi-efficient. If everyone becomes a passive indexer, then the returns of the major indexes will start to lag in a major way as the stocks in the index become overowned and overpriced.

But there are other considerations too. Passive ownership essentially gives management a free pass and allows lousy management teams to stay entrenched.

As Ackman writes,

As index fund ownership grows as a percentage of shares outstanding, the voting power of index fund managers increases. While on the one hand, one might believe this is good for America as these “permanent” owners should think very long term compared with the many investors whose average holding period is less than one year.

On the other hand, there are significant drawbacks… While index fund managers are, of course, fiduciaries for their investors, the job of overseeing the governance of the tens of thousands of companies for which they are major shareholders is an incredibly burdensome and almost impossible job. Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index…

Of course, this is impossible. Index managers are passive and will generally toe the line for management. Ackman points out some very significant long-term effects of this, asking the proverbial question of what happens when index funds effectively control corporate America:

If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America? Courts have often deemed shareholders to be in control of a corporation with as little as 20% of the ownership of a company. At current rates of asset inflows, it will not be long before index funds effectively control Corporate America and the corporations of many foreign countries.

The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise. Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors…

The thought of corporate America turning Japanese should be enough to make even the biggest proponent of indexing pause for a moment.

Ackman says that the “greatest threat to index fund asset accumulation is deteriorating absolute returns and underperformance versus actively managed funds” because money flows into these funds with no consideration of value. I agree, and would add that this was the major rationale for the “smart beta” movement.

But perhaps the greatest takeaway here is simply to not give up on active management. When you invest outside of the mainstream, you will have returns that are outside of the mainstream. That means that there will be plenty of years when you underperform.

But if you’re a good investor, it also means that there will be years where you massive outperform. So keep your chin up. Even hedge fund masters of the universe lose money some years.

Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas. As of this writing, he was long KMI and TK.

Photo credit: InsiderMonkey


4 Responses
  1. Alex Jamieson

    I wonder too with index funds if this is a cyclical fad in some regard. The markets have been strong particularly in the US for a number of years. As the valuations get stretched the active managers will naturally underperform as they struggle to find value. Investors get frustrated and would likely move from active to passive chasing the returns. It is not until there is a major shake out that people start to return back to active management and the cycle starts again.