This week March 30, 2018, we look at whether it is possible to get an “information interpretation edge” in terms of taking advantage of market participants overreacting to information that is publicly available.
We also look at how indices are reconstituted, how index funds and ETFs track their underlying benchmarks, tracking error and securities lending.
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Welcome to Money For the Rest of Us Plus. This is the companion episode to episode 198, Capitalism is Creation. It is Saturday morning, March 30th. In today’s episode we’re going to talk a little bit about market efficiency and what’s priced in, and discuss small cap stocks, particularly companies that graduate and grow and are spectacularly successful and move out of the small cap index.
Comments On Podcast Episode 198
First off, let me share some comments on the regular podcast, episode 198. It was a difficult episode to do because I was contrasting different things and one of the challenges is, foremost, I probably could’ve used the term socialism different. There’s many, many different types of socialism. I did not mean to imply that millennials want state controlled economies. By no means that, even though I gave some examples of Venezuela, Cuba. In fact, I wasn’t really trying to imply millennials wanted anything, because you can’t really make such generalities about any age cohort. I was really trying just to emphasize the importance of … give some examples of businesses that started small, grew, and maybe didn’t think of themselves as capitalists, but in reality, are.
We also recognize there’s challenges with capitalism. Certainly some significant challenges, as there are with any type of economic system. Please, I hope you didn’t take away that I thought millennials or any age group was a certain way. I quoted some specific millennials and used that to contrast state controlled economies versus capitalism. I do, and I did say in the episode, I believe many millennials will be the ones that recreate or reconfigure how our economic system will work. I think they’re at the forefront of doing that. So, I’ll leave that at that.
I had a question from a member. He writes, “We talk about efficient markets as being efficient, because all information is priced in. What I don’t get is that it’s not the access to information that matters, it’s the interpretation of it that does. Is it legitimate that you could have an interpretation of information edge on a stock or category?”
Yes, I think you can. In fact, I think that’s what investing is. I’ve always, even as an undergrad in Finance, I’ve been uncomfortable with the concept that, well, all the information is priced in. I just don’t think that’s the case. I think securities and asset classes get mispriced. I think the challenge is, is being able to take advantage of those mispricings. The basis of value investing is that investors become overly negative on a particular security or asset class and it’s mispriced. That is fundamentally what value investing is. It’s saying that this asset is mispriced compared to its prospects.
Growth investing, investors can fall in the same trap. I’ve a friend that bought in, just recently, bought into some the biggest name in tech stocks, such as Amazon andFacebook because they’ve dominated, with the idea they will continue to dominate. What we have to realize with any type of investing, it’s not enough for a company or stock to grow spectacularly well and to dominate, it has to do better than what’s already assumed by the investors. If it’s priced with a very, very high price-to-earnings ratio, that means the assumption is the company’s earnings will grow very, very fast. In order for investors not to be disappointed and for that stock not to fall in price, the company has to exceed those expectations. Anytime we’re investing, we’re always making assumptions how … What’s the market assuming? What are investors already assuming? Particularly if we’re buying individual stocks, we’re assuming that investors are wrong, otherwise why would we … There’s just no reason to buy it. You might as well buy the market via an index fund or ETF.
Now, on Money For the Rest of Us Plus, I believe asset classes get mispriced. People get overly zealous. They get overly fearful. It doesn’t happen very often. Most of the time we’re just waiting around. We have a diversified portfolio and there are times when an asset class appears to be undervalued. Real estate investment trusts are like that right now. Even with REITs it’s not clear cut. If it was completely clear, then REITs wouldn’t be down 12% and mispriced. There is this sentiment, and that’s why we look at valuations, we look at market internals. What is the level of fear and greed? What is that momentum or trend priced into different asset classes? We look at the economic trends. How is that influencing those valuations? We combine all three, then we make our best judgment in terms of risk analysis.
At the end of the day I believe that all investors interpret information and that all the information just isn’t priced in. Maybe all the information is there, but what influences the price is definitely investor expectations. As long-term investors, there’s times we can take advantage of that. Sometimes we just buy and hold, waiting for those opportunities to take place. Sometimes when something is overvalued, we have less allocation to it. US stocks as example, especially those big cap tech names have had a really rough time this quarter and have underperformed because they disappointed. That’s my comments on that.
Small Cap Indices
Let’s turn to another question from a member. He asked, “I’m wondering about inaccuracies in funds that are designed to track a certain index. Specifically tracking a small cap index. My understanding is that index funds aren’t guaranteed to own all the stocks in an index. They just attempt to track the value of that index. Does that lead to tracking error over time? I’m thinking specifically as a situation whereby a small cap company makes it big and grows outside of its index. Would a mutual fund ETF tracking small cap stocks then sell the stock? Wouldn’t that lead to forfeiting your jackpot’s profits and therefore, in real life, lagging the returns that are theoretically achieved by owning the whole small cap market? Has small cap index funds existed for long enough to know whether this has been much effect in the long run?”
Multifaceted question there. First off, most mutual funds and ETFs are tracking an underlining index, so the iShares Russell 2000 Index ETF is tracking the Russell 2000 Index. That index is put together by Russell. It’s made up of roughly 2,000 small company US stocks. Indeed, every year, some of those stocks move out of the index. Some are added. Some are taken away. Every year, every June, Russell reconstitutes the index. It last did this in June 2017. There were 137 companies in that reconstitution that left the Russell 2000 Index; 31 of them moved to the Russell 1000 Index. They got to be big enough that they were no longer a small cap company. Examples were Webster Financial, Bank of Ozarks, PrivateBancorp.
Then, there were other ones that were no longer small cap because they got smaller. They became more of a microcap company. There were 71 companies that moved out of the Russell 2000, became a micro cap. At the same time, there were 42 companies that were no longer large company stocks or 42 stocks that went from the Russell 1000 Index into the Russell 2000 Index. He’s correct. There is movement all the time. If a company leaves the Russell 2000 because it got too big and continues to grow, then, as an investor in small company stocks, using that particular index or a fund tracking that index, you would miss out on that.
I don’t think it’s been a meaningful impact on performance. If we look at the Russell 2000 for the 15 years ended, I believe, probably ending February, it’s returned 11.55% annualized. The Russell 3000, 10.26% annualized. The Russell 3000 would be large company stocks and small companies. It’s trailed just a purely small company index, which suggest that small cap stocks did do better than large company stocks.
Now, there’s no data that I’m aware of that you could track the overall performance of companies that left the Russell 2000 because they did better, whether they had outperformed other aspects of the … Essentially, do they outperform the overall small cap index? Now, the way to avoid that, if you want to make sure you hold all of them, is to own the Russell 3000 Index, which has small, mid, and large company stocks. Then, as the companies graduate because they’ve done well, they’re still a part of the Russell 3000 Index, so you still own them.
Now, this concept of tracking error and replication, most of the US ETFs fully replicate the index, so the iShares Russell 2000 Index ETF owns all the stocks in the Russell 2000, or the vast majority of them. The tracking error has been very close. By tracking error, we’re looking at what is the return of the ETF relative to the return of the underlying index. In fact, with many of the ETFs, they’ve done slightly better than the underlying benchmark. I looked at the performance of the Russell 2000 ETF. It has 1,988 holdings for the 10-year period. Again, I believe it’s ending February 2018. It returned 8.75% compared to 8.71% for the Russell 2000 Index. How did it outperform? That’s out performance after taking out the expense ratio. Essentially, it was free to own that ETF.
Well, BlackRock, who owns iShares, is active in securities lending. Again, this ETF owns 1,988 companies. There are investors out there, institutional investors, that want to short some of those small company stocks. In order to short those stocks, you have to be able to borrow the shares from someone. By shorting, you want to profit when the price of the stock potentially goes down. To borrow that, they have to go to their broker and borrow the shares. Well, their broker needs to get access to the shares. They go to someone like BlackRock that’s a longterm investor in these underlying companies, because they manage these ETFs. They do what’s known as security lending. Where they exchange the stock for some collateral. Usually, it’s US treasury bills, and then BlackRock iShares earns a fee for lending out that holding. BlackRock, I saw one report that shows that they share 70% to 75% of those proceeds, revenues from securities lending to the holders of the fund. Those ETFs are generating a little bit of income, more than enough to offset the expense ratio from the securities lending. That’s another aspect.
Back to this tracking error. The tracking error is very close, because it’s fully replicated. Now, if it’s a very niche strategy … I tried to find, think about what ETF would be most difficult from a tracking error perspective to replicate the index? Capitalization-weighted ETF are fairly easy to track. The capitalization is the number of shares outstanding by the price. The reason why most index funds are capitalization-weighted or indices is because you don’t have to rebalance all the time, because as the price of a stock goes up, then it becomes a larger share of the index, so you’re not having to rebalance.
With an equal-weighted ETF where each holding has an equal percentage weight within the fund, you’re having to rebalance at some time. Maybe it’s monthly, quarterly to get everything equal-weighted again. That can lead to tracking error. The one ETF I found, I think it was called the Guggenheim Equal Weight Emerging Markets Country ETF. Now, the MSCI Emerging Markets Index Index has 864 holdings. Can you imagine trying to run an equal-weighted portfolio of all those holdings? That’s what the Guggenheim fund did. They must’ve found it extremely difficult to do, because they changed the benchmark. Now, it’s no longer the MSCI Equal Weighted ETF, it’s the Equal Weighted Country ETF, so every country within that emerging market’s ETF has the same weight. Not necessarily every holding, because, I suspect, because some of these rebalancing and tracking error issues.
The other type of ETF that theoretically would be more difficult to track would be bonds. With the Bloomberg Barclays Aggregate Bond Index having thousands of bond holdings, many of which wouldn’t be terribly liquid. When I looked at the tracking error, the difference for, let’s say, the iShares Barclays aggregate ETF, it’s tracking was very close to the underlying index. Surprisingly, tracking error has been very good for ETFs. They’ve been able to do it very, very well. It generally has not been something … It used to be much more difficult to do. Most ETFs will fully replicated their benchmark’s underlying holdings, at least most US based ETFs.
Getting back to the original question, yes, each of these indices get reconstituted. The smaller the segment, the more likely there’ll be turnover of holdings within that. The way to mitigate that, is to own broader indices or ETFs, so hold the Russell 3000 instead of the Russell 2000.
That is Plus episode 198. We’re at the end of the month. I’ll be working on the April 2018 Investment Conditions report and we’ll release that next Saturday, the first Saturday in April.