Bill Gross Misfired at Janus. But He Had the Right Idea.

Active bond managers could use more of Bill Gross’s swagger.  

No sooner had the hall-of-fame bond manager announced his retirement on Monday than the financial press declared his downfall. The Wall Street Journal headline proclaimed “Bill Gross, Onetime Bond King, Retiring After Messy Last Act,” and another in the Financial Times read “How the ‘bond king’ Bill Gross lost his crown.”

That messy last act refers to Gross’s stint as manager of the Janus Henderson Global Unconstrained Bond Fund since 2014. Gross made some big bets at Janus Henderson that didn’t pay off, most famously a wager last year that rates on U.S. Treasuries and German bunds would converge, resulting in sagging performance for his unconstrained bond fund.

Even though Gross’s calls didn’t turn out the way he and his investors had hoped, Gross was right to bet boldly on his best ideas, and active bond managers would be wise to follow his example.

The pivot to unconstrained investing was a brave departure for Gross, who had spent the previous three decades perfecting the “total return” approach to bond investing with the Pimco Total Return Fund he founded in 1987. The strategy attempts to outpace the broad bond market by taking modestly more risk, often by buying lower-quality bonds than are reflected in broad-market bond indexes while targeting a similar average maturity.

No one did it better than the Bond King. The institutional share class of Gross’s total return fund outpaced the broad bond market, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, by 1 percentage point annually during his run from June 1987 to September 2014, a huge margin for a bond manager. And he did it with only modestly more risk, as measured by annualized standard deviation (4.3 percent for Gross’s fund compared with 3.9 percent for the index).

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Jeffrey Vinik Thinks He Can Beat the Stock-Picking Bots

Stock pickers are striking back. 

Jeffrey Vinik, who rose to fame as manager of the Fidelity Magellan Fund in the 1990s, told CNBC last week that he was getting back into the stock-picking game. He will resurrect Vinik Asset Management, a hedge fund he closed in 2013.

Only this time, Vinik won’t just be competing with the market and other managers. He will also have to outmaneuver the computers that are increasingly displacing stock pickers.

It’s a brave move. Stock pickers have struggled to perform in recent years and investors are abandoning them. Actively managed stock mutual funds have experienced net outflows for five consecutive years, a total of $918 billion from 2014 to 2018, according to estimates compiled by Bloomberg Intelligence. Hedge funds managed to hang on to their assets for most of that period, but after a disappointing 2018, investors are pulling money from them, too.

While others bemoan a profession in decline, Vinik sees a resurgence. “I think this is an incredible opportunity for old-fashioned stock picking,” Vinik told CNBC. “We’ve had decades, maybe 10 or 20 years, of active managers underperforming passive managers.”

It’s fashionable to blame a bad environment for stock picking for active managers’ woes, but it’s not entirely true. Sure, value investing has lagged the broad market over the last decade, but other styles of active management, such as growth, quality, momentum and low volatility, have beaten the market. In other words, active managers have underperformed, not active management.

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Growth Stocks Are on the Firing Line in the Trade War

Investors in U.S. growth stocks have been richly rewarded in recent years, but their fortunes are set to turn if President Donald Trump can’t resolve his trade disputes. 

Bloomberg News reported on Wednesday that China and the U.S. had wrapped up three days of trade talks and “expressed optimism that progress had been made.” For Trump, that’s a clear departure from his usual tough talk on trade.

That shouldn’t be surprising. As I pointed out recently, the president fancies himself a champion of American business and gauges his success by the level of the stock market. The market’s steep drop in December signaledthat the country’s biggest companies, which dominate market barometers such as the Dow Jones Industrial Average and the S&P 500 Index, are under increasing stress. They generate much of their revenue overseas, so Trump’s trade disputes are an obvious concern.

If the president was hesitant to connect those dots, Kevin Hassett, chairman of the White House Council of Economic Advisers, was not. He told CNN last week that “There are a heck of a lot of U.S. companies that have sales in China that are going to be watching their earnings being downgraded next year until we get a deal with China.” That was a day after Apple Inc. cut its revenue outlook, blaming in part weaker demand in China.

But Trump’s trade policies don’t affect all companies equally. Growth companies, or those that are expected to grow faster than average, sell more of their products overseas than slower-growth value companies. That means they have more to gain from free trade and, of course, more to lose during a trade war.

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Professor Has Some Questions About Your Index Funds

Lu Zhang, a finance professor at Ohio State University, has something to say about your hot new index funds, and it may not be flattering. 

Not long ago, the typical investment portfolio was a grab bag of stocks, bonds and actively managed mutual funds. Today, it is more likely an assortment of index funds. And not just any index funds. Indexes are no longer content to simply track the market. A growing number of them are attempting to replicate traditional styles of active management, also known as “factors.” I counted roughly 900 mutual funds and exchange-traded funds in the U.S. that track factor indexes, and that number is likely to grow.  

The pivot to indexing may be new, but it was cultivated by decades of research in economics and finance, which gives it the imprimatur of science, or at least robust inquiry. But a new generation of academics, Zhang prominently among them, are re-examining the research and finding much of it questionable. Their work could derail the indexing revolution and, as might be expected, index providers and fund companies aren’t likely to be happy about it.   

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These Tools for Picking Stocks Sometimes Even Work

Like stocks that have low price-to-earnings ratios? How about ones that have outpaced the market? Or shares of small companies? Those are known as factors: quantifiable characteristics that some money managers use to identify stocks associated with above-market returns. But factor investing is tricky. Sometimes it pays; other times it doesn’t. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate whether factor investing is worth the effort. They previously discussed corporate debt.

Nir Kaissar: It’s widely acknowledged that some factors have historically outpaced the broad market.   

For example, companies that are cheap relative to earnings, cash flow or book value have beaten the market during the past six decades. The same is true of small companies and highly profitable ones.

In a 2017 paper titled “Replicating Anomalies,” economists Kewei Hou, Chen Xue and Lu Zhang identified 67 factors that have produced statistically significant outperformance from 1967 to 2014. In other words, the success of those factors most likely isn’t attributable to chance.   

Seeing an opportunity, fund companies have rolled out a dizzying variety of factor funds in recent years. Investors have poured $762 billion into exchange-traded funds that track factor indexes, according to Bloomberg Intelligence. That’s up from $98 billion at the end of 2007.  

But the question is whether factor investing will continue to pay. Many investors are skeptical. Returns for value investing, arguably the best-known factor, have lagged the market for more than a decade. Meanwhile, broad market indexes such as the Standard & Poor’s 500 Index, which have no meaningful factor exposure, have been among the best performers.

The answer may depend on why factor investing has been profitable in the first place: Is it compensation for taking additional risk or an opportunity to exploit other investors’ mistakes? It’s a hotly debated question, and it relates not only to factor investing, but to how the markets work more generally.  

Noah Smith: I think there are two main questions about factor investing, and you’ve already touched on both.

The first question is what these factors are. Why did things like value, size and momentum show outsized returns for so many decades? Efficient-markets theory says that these outsized returns represent compensation for taking risk — for example, that small stocks sometimes crash even when the market as a whole is not crashing.

As asset manager Cliff Asness has pointed out, that interpretation sort of makes sense for factors like size and value that represent long-term characteristics of companies. But for momentum, it doesn’t really make sense — companies that have high momentum one year often have low momentum the next. It looks like the momentum premium is simply free money, the product of some enduring market inefficiency. This question is important because investors deserve to know whether factor investing is actually increasing their risk, or whether they’re beating the market.

The second question is how long factors persist. You’ve already noted that the value premium has been shrinking over time. But a lot of factors decay even faster. A 2015 paper by economists R. David McLean and Jeffrey Pontiff found that when academics publish a paper about a factor, it tends to shrink or disappear shortly afterward. But a factor tends to hold up between the time they’re discovered and the time the paper is published, implying that the disappearance isn’t a result of publication bias. Instead, this suggests that the market is full of small inefficiencies, which academics and investors are constantly discovering and correcting, and which temporarily manifest themselves as factors.

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Investors Deserve a Peek at Bond Managers’ Tricks

Active bond managers have dazzled investors by outpacing the bond market in recent years. But it’s a simple sleight of hand, and the big reveal is coming.    

The trick is that bond managers have been quietly loading up on low-quality bonds. They pay a higher yield than top-quality ones to compensate for their greater risk of default — in technical parlance, a credit premium.

When times are good, as they have been in recent years, there are few defaults because borrowers have little trouble paying their debts. Bond managers collect their credit premiums and easily beat the broad bond market indexes, which tend to be dominated by high-quality bonds.

When the economy slows, however, the defaults start to pile up, handing losses to holders of low-quality debt. And suddenly bond managers don’t look so smart.  

It’s a worthwhile trade-off for managers. The booms normally last longer than the busts, which means that credit premiums are usually a boost to performance. And nothing attracts investors like a hot hand, or the appearance of one.

But it’s not great for investors. They often don’t realize that their bond manager is taking more risk until the losses show up. And investors who want riskier bonds can almost always buy them more cheaply through index funds. They would be better served by a closer inspection of bond managers’ tricks of the trade.

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Value Versus Growth Plays Out in Emerging Markets

Emerging markets are flashing warning signs, but don’t tell that to value stocks.

The MSCI Emerging Markets Index is down 19.2 percent from its recent high on Jan. 26 through Friday as investors wring their hands over tariffs, slow growth, a rising dollar and numerous other fears.

To some investors’ surprise, value stocks are holding up better than growth. The MSCI Emerging Markets Value Index is down 18.3 percent, while the MSCI Emerging Markets Growth Index is down 20.1 percent.

In theory, that’s not supposed to happen. Value stocks, after all, are cheaper than growth for a reason: They represent companies, and sometimes whole sectors, that have fallen on hard times or are struggling to grow — think banks and brick-and-mortar retailers. Those problems are compounded in a downturn. And as goes the business, so goes the stock.

But in reality, stocks haven’t always followed that playbook, at least in the U.S. I counted 13 U.S. bear markets since 1926, as defined by a decline of 20 percent or more in the S&P 500 Index for the longest period for which numbers are available. I’m also counting the periods from September 1929 to March 1935 and from March 1937 to April 1942 as a total of two bear markets.

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Dance of Investing Styles Doesn’t Signal a Downturn

The U.S. stock market notched yet another record on Wednesday, and many investors are anxiously looking for signs of a slowdown.

Perhaps not coincidentally, researchers at Sanford C. Bernstein & Co. say they’ve spotted one. According to Bloomberg News, Bernstein has found that correlations among investment styles — or factors — such as value and momentum “have shot to all-time highs.”

That means they are moving in the same direction, and that is apparently a bad omen. As Joseph Mezrich, managing director at Nomura Securities International Inc., told Bloomberg, “In the past factor correlation has tended to rise in periods of macro stress.”

The concern is likely to interest more than just wary investors. Factor investing is increasingly popular. Investors have poured $352 billion into value, momentum, quality and other factor exchange-traded funds since 2013, according to Bloomberg Intelligence, nearly double the $191 billion in factor ETFs at the end of 2012.

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Mid-Cap Stocks Aren’t Ready for a Starring Role

I can’t open a web browser lately without seeing a banner promoting State Street Corp.’s new digital series “Crazy Enough to Work” starring actress Elizabeth Banks — who, I must confess, I think is fabulous.

The series profiles four midsize companies. The first two episodes showcase EPR Properties and the New York Times Co. and have already been released. The final two feature Dunkin’ Brands Group Inc. and the Boston Beer Co. and will be available on Aug. 29 and Sept. 12, respectively.

It’s all a plug for State Street’s SPDR S&P MidCap 400 ETF, which makes me wonder about those algorithms supposedly customizing my online experience. I’ve never expressed any interest in buying a mid-cap stock fund.

It’s not that I have anything against mid-caps. On the contrary, I own them like nearly everyone else. I’m defining mid-caps as stocks with a market value of $1 billion to $10 billion. If you own a large-cap stock fund, chances are you own some mid-caps, too.

Consider that there are 458 mid-cap stocks in the Russell 1000 Index, which collectively make up 8.9 percent of the index. Mid-caps make up an even bigger chunk of the broader market. There are 1,429 mid-caps in the Russell 3000 Index, accounting for 14.6 percent of the index.

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FAANGs Are More Solo Acts Than a Tech Supergroup

It’s time for FAANG stocks to break up, at least in investors’ minds.

Facebook, Apple, Amazon, Netflix and Google parent Alphabet can’t get away from one another. Every time one grabs the spotlight —  as Apple did last week when it became the first  U.S. company with a $1 trillion market value — it brings along the other four.

They’re alternately hailed as the hot stocks, technology’s brightest lights and indispensable growth companies, and jeered as a worrisome sign of a frothy and top-heavy market. But look closely and it’s no longer clear why they should be lumped together at all.

Let’s start with the technology moniker. Amazon is a retailer and Netflix is an entertainment company, which is why, contrary to popular perception, the Global Industry Classification Standard, or GICS, tags them as consumer discretionary companies, not tech. And as of the next GICS reclassification in September, Facebook will move from the tech sector to telecommunications, where it belongs. Only two of the five FAANGs, in other words, are true technology companies.

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