Review & Outlook

Our take on the investing, financial, & economic themes of the day

There’s No Such Thing as Passive Investing

Benchmarking in most businesses makes sense. But in investment, it prompts investors to outsource their judgment to a few indexers that have become the world’s stockpickers of last resort.

John Authers, Financial Times

One of the best arguments for the success of active management as an investment strategy is Vanguard — that’s right, Vanguard, the mutual fund and ETF giant founded by Jack Bogle and known for preaching the mantra of “passive management.”  Most people don’t know it, but Vanguard runs some of the top actively managed mutual funds in the business.  For example, as Lewis Braham pointed out in Barron’s last summer, the Vanguard Health Care fund (VGHCX) had achieved a 12.3% 10-year annualized return, whereas the iShares U.S. Healthcare Exchange-Traded Fund (IYH) has returned 10.2%, and the iShares ETF charges a higher fee to boot.

Vanguard is yet again demonstrating the power of active management.  This time, however, the results may be much less sanguine for its investors than the outperformance of its healthcare fund.  Earlier this month Vanguard made the decision to incorporate mainland Chinese A-shares into two important funds: the Vanguard Emerging Markets Stock Index Fund, and the Vanguard FTSE Emerging Markets ETF.  China enforces strict controls over its equity markets, which have prevented most international investors from holding Chinese stocks, or A shares, directly.  Chinese authorities have partially liberalized those controls to allow a quota of foreign investors into the market.  In response, Vanguard has made the decision to begin incorporating A shares into its emerging market funds.  It follows FTSE Russell, the index provider group now owned by the London Stock Exchange.  The decision to incorporate Chinese A shares, like the categorization of national markets as “frontier,” “emerging,” and “developed,” is a prudential judgment based upon a host of qualitative, mostly unquantifiable factors, which is a far cry from the algorithmic and mechanical procedures commonly associated with index investing.

The further irony is that just as Chinese equity markets have become more structurally open to investment, those stocks themselves look less and less desirable: Chinese stocks, especially small caps, are being bid up and up to nosebleed valuations.  These facts are not unrelated, of course, because the anticipation of new foreign money flowing into Chinese stocks only drives up prices further.  It’s notoriously difficult to identify bubbles until after they’ve popped, but the evidence for a bubble in Chinese stocks is probably about as compelling as it gets.  The Shanghai Composite is up 50 percent this year and the Shenzhen market has increased more than two-fold year to date.

chinese stocks

Source: Financial Times

According to the Financial Times, companies listed on the Shenzhen started this year with an average price-to-earnings ratio of 35; the average now stands at 72.  (By comparison, the trailing p/e of the S&P 500 Index is now about 20.7.)  Chinese small-cap stocks are even more expensive with a p/e of 123.77 and the rally has been disproportionately due to smaller, riskier companies.  The surge in Chinese stocks has come even as the underlying economy has sputtered and growth has slowed to its lowest point since 2009.  James Mackintosh of the FT has produced a fascinating chart that shows how the fortunes of emerging market stocks generally are linked with the health of Chinese industry (represented by the price of China steel rebar), but Chinese stocks seem to have decoupled from their own economy.

chinese stocks decouple

Source: Financial Times

China’s loose monetary policy is also contributing to the stock surge, as the central bank has cut borrowing rates.  Although the central bank’s chief goal may be to make China’s huge public and private debt load serviceable — Chinese debt stands at 250% of GDP, up 100 percentage points in five years, according to the Economist — one effect of easy money is to inflate risk assets like stocks.  The Economist reports that margin trading has helped drive stocks as well, with outstanding loans to stock investors up more than 300% over a one year period as of April, reaching a record 1.67 trillion yuan or $269 billion.  It also reports,

many of those rushing to snap up stocks are small-time day traders with little understanding of what they are buying. Chinese investors opened nearly 5m trading accounts in March, a stampede that has continued into April. A survey by China’s Southwestern University of Finance and Economics found that two-thirds of new investors last year did not complete high school.

All of these factors show why it’s probably foolish to buy Chinese stocks indiscriminately right now.  It may be in part why MSCI has decided to defer adding A shares to its widely-followed emerging market indices.  In any case, the divergence between MSCI and Vanguard/FTSE Russell over Chinese A shares shows why there’s really no such thing as “passive” investing.