A Face-Off Between Passive and Active Investing
US Global Investors
By Frank Holmes
December 15, 2012
A Face-Off Between Passive and Active Investing
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
Exchange-traded funds continued to attract assets in 2012 while money has been exiting mutual funds. Still a majority of assets continue to be invested in actively managed products: As of the end of 2011, of the nearly $13 trillion invested in funds, index and exchange-traded funds comprise only about 8 percent, according to the Investment Company Institute.
As active investment managers who have experienced bull and bear markets, the financial industry’s deregulation and re-regulation, and the shifting needs of baby boomers, we are pleased that actively managed mutual funds continue to be the choice for a significant portion of portfolios.
The ETF industry has matured from its adolescent days, yet it continues to morph in puzzling ways that produce mediocre results. In my blog, I’ve discussed some eye-openers to help investors understand the risks of ETFs before putting their money in a product that might end up with unexpected outcomes.
Take the relatively new iShares MSCI Global Metals & Miners ETF (PICK), which began trading at the beginning of February 2012. The ETF is based on the MSCI ACWI Select Metals & Mining Producers Ex Gold & Silver Investable Market Index, which is a non-diversified basket of companies located in developed and emerging markets that are involved in producing or extracting metals or minerals. Its 10 largest holdings make up 50 percent of the index, which makes it a more concentrated, potentially more volatile, portfolio.
By comparison, as of November 30, 2012, the top 20 holdings in the Global Resources Fund (PSPFX) make up 43 percent of the overall portfolio.
In theory, one chooses a natural resources investment to gain access to the companies that stand to benefit from the world’s growing needs of natural resources. In addition, commodities offer portfolio diversification, as they have historically had a lower correlation to the overall market.
However, in a faceoff, PSPFX would steal the puck from PICK, as the Global Resources Fund has outperformed the ETF by nearly 13 percentage points since PICK’s inception in January 2012.
PSPFX also added significantly more return with less risk compared to the ETF over the same timeframe. The Global Resources Fund experienced an annualized standard deviation of 15.95 percent compared to the PICK ETF, which had an annualized standard deviation of 24.34 percent, according to Morningstar Direct.
You can also compare two gold equity investment vehicles. Although gold miners have had a challenging year, the Gold and Precious Metals Fund outperformed the Market Vectors Gold Miners ETF (GDX) by 400 basis points.
As I often remind investors during presentations, there is no free lunch on the commodities table—every investment comes at a cost or a risk. When it comes to emerging markets and commodities, there are inefficiencies that we believe give active managers an edge. In emerging markets, the capital markets are not as sophisticated as in developed markets and the information can be less uniform and straightforward. Managers who have an explicit and tacit knowledge of the country and its way of doing businesses are likely able to flush out the best opportunities. We believe it is worth paying a bit more in management fees to get the expertise needed for these specialized markets.
The Eastern European area is a good example of a nuanced market. While the presidential reelection of Vladimir Putin in Russia caused markets to stress over how he would lead the country, Turkish stocks have experienced substantial growth. U.S. Global Investors’ Eastern European Fund (EUROX) benefitted from its ability to invest in the entire area: Russian stocks make up only about 37 percent of the fund while Turkey comprises 17 percent of the fund. See the fund’s regional breakdown here.
We believe this is why we have significantly outperformed the Market Vectors Russia ETF year-to-date as of December 13, 2012:
Indexers often argue that active managers have periods of underperformance. Fellow Canadian Wayne Gretzky has been called the greatest hockey player ever, holding or sharing more than 60 records that he collected during his 20 seasons of playing in the National Hockey League. He holds the NHL record for the most hat tricks—achieving three goals in a single game more than 50 times—and when he retired, Gretzky was inducted into the Hockey Hall of Fame.
However, under asset management’s rigid standards for active managers, the “Great One” might be considered a loser, as his team won the Stanley Cup “only” four times.
From time to time, active managers underperform; yet, they have the opportunity to add alpha. ETFs, on the other hand, are built to only match the benchmark and are never expected to beat it.
While ETFs offer instant execution, liquidity and lower fees, certain passive investments may not get you where you want to go over the long-term. The “hat trick” equivalent that Global Resources, Gold and Precious Metals, and Eastern European Funds has been able to achieve this year against their respective ETF peers is more diversification, better historical performance and less volatility.
- The major market indices finished lower this week. The Dow Jones Industrial Average fell 0.15 percent. The S&P 500 Stock Index lost 0.32 percent, while the Nasdaq Composite dropped 0.23 percent. The Russell 2000 small capitalization index closed the week with a 0.18 percent gain.
- The Hang Seng Composite rose 2.01 percent; Taiwan gained 0.74 percent, while the KOSPI increased by 1.92 percent.
- The 10-year Treasury bond yield rose 8 basis points this week, at 1.70 percent.
Domestic Equity Market
The S&P 500 Index fell modestly this week after stringing together gains for three weeks in a row. The materials sector was the standout performer this week, while the consumer discretionary sector lagged.
- Materials rallied this week as iron ore and steel names rallied on improving sentiment toward a Chinese recovery as HSBC’s Flash Purchasing Managers’ Index (PMI) for December indicated accelerating activity. Cliffs Natural Resources, U.S. Steel, and Allegheny Technologies were the leaders. Chemical names were also strong on lower natural gas prices and improving prospects for a global pick-up in activity.
- The telecommunication services sector also rallied this week on mergers and acquisition activity in the space.
- J.C. Penney was the best performing stock in the S&P 500 this week, up 15.47 percent. The stock has been volatile in recent months as the company’s turnaround strategy has been viewed skeptically by the investor community. The stock was up this week on a more promotional approach as opposed to the “everyday low price” strategy that has defined the turnaround.
- The consumer discretionary sector was the worst performer this week, driven lower by apparel and shoe makers and related retailers.
- The utilities sector also underperformed, although the sector had performed well in recent weeks after selling off due to dividend tax fears in the aftermath of the election.
- Family Dollar Stores was the worst performing stock in the S&P 500 this week, falling 7.24 percent. The company gave cautious guidance for the fourth quarter, citing cautious consumers and tough competition.
- The market has been resilient even as the fiscal cliff remains uncertain, giving hope the market can continue its historical, seasonal strength into year end.
- There has been a lot of economic data noise due to Superstorm Sandy that will likely depress reported economic results for November.
Treasury bond yields were higher this week as the Federal Reserve announced an additional $45 billion in quantitative easing (QE) this week. This was expected, but a surprise was the elimination of the pledge to keep rates low through mid-2015, which was replaced with numerical thresholds on unemployment and inflation expectations. The Fed also planted the seed regarding the removal of stimulus, saying that it would do so in a balanced way. This could be construed as slightly more hawkish than the market expected. The current QE program is now on pace to “print” $1 trillion per year until the economy improves. The chart below depicts the massive expansion of the Fed’s balance sheet that has already occurred and the likely path going forward.
- The Fed remains committed to more monetary easing and regardless of how the “fiscal cliff” pans out, fiscal policy will become more restrictive. The economy is unlikely to be robust next year and inflation is likely to remain contained.
- Industrial production rose 1.1 percent in November bouncing back from Superstorm Sandy-induced slowness in the prior month.
- HSBC’s China Flash PMI for December rose to a better-than-expected 50.9, indicating manufacturing expansion.
- The NFIB Small Business Optimism Index fell precipitously in November, likely driven by the election outcome and fiscal cliff concerns.
- Eurozone industrial production fell 1.4 percent in October after falling 2.3 percent in September.
- The bond market witnessed a modest sell-off this week even as the Fed upped the ante with additional quantitative easing.
- For fixed income investors, it appears the day of reckoning (sharply higher yields) is still well in the future.
- Homebuilding is expected to add to gross domestic product growth this year for the first time since 2005. Though home construction accounts for only about 2.5 percent of GDP, economists estimate that for every new house built, at least three new jobs are created.
- The “fiscal cliff” is front and center on investors’ radar. If a compromise cannot be reached, that would be a negative for the market and economy.
- Europe appears to be on the verge of another crisis, but policymakers continue to bicker, just adding to the uncertainty
For the week, spot gold closed at $1,696.10, down $7.95 per ounce, or 0.47 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 1.12 percent. The U.S. Trade-Weighted Dollar Index fell 1.06 percent for the week.
- There were two mining deals this week which we benefited from. Primero Mining announced that it has entered into a definitive agreement with Cerro Resources whereby Primero will acquire all of the issued and outstanding common shares of Cerro. The offer represented an implied 62 percent premium to Cerro’s 20-day volume weighted average price and a 77 percent premium to the spot closing price the prior day. Mirasol Resources monetized its 49 percent stake in the Joaquin silver-gold project for consideration of $60 million ($30 million cash and $30 million of the acquirer stock). The transaction leaves Mirasol a portfolio of exploration properties in Argentina and Chile with enough cash to fund exploration activities for the next five years.
- We also saw very positive drill results come through from Atna Resources. The company announced additional results of underground development drilling at its Pinson Mine showing intercepts and gold grades of 13.7 meters at 31.2 grams per ton, 9.1 meters at 27.5 grams per ton, and 6.1 meters at 44.8 grams per ton. In addition, Torex Gold reported some exceptional drilling results on the company’s Morelos Gold Project. Its highest-grade intercepts yet were 21 meters carrying 30.3 grams per ton of gold, 44.2 grams per ton silver and 1.1 percent copper. At spot prices, a ton of this ore is worth $1,780, well more than the typical 1 gram per ton ore ($55 value) deposits that the majority of the gold industry is mining.
- Sales of American Eagle one-ounce gold bullion coins more than tripled in November of this year, from 41,000 ounces sold in November 2011 to 131,000 ounces. The U.S. Mint also reported that total gold sales increased 132 percent from 59,000 ounces in October 2012 to 136,500 gold ounces in November 2012.
- We fortunately did not have any exposure to Centamin’s shares, which fell 50 percent midweek as the Egyptian government cut off fuel supplies to the company’s Sukari mine and customs officials halted the export of its gold for sale. An analyst at Canaccord’s London office wrote that the shares may fall 80 percent.
- Kirkland Lake Gold reported essentially a production miss of 50 percent below guidance this week and the stock dropped intraday its most in 13 years. Our funds did not have any exposure.
- According to Statistics South Africa, the country’s gold output fell by 45.7 percent in volume in October, largely due to the labor unrest, while total overall mineral production was down 7.7 percent compared with the same month in 2012.
- Dalman Rose’s gold team noted it believes that rising costs have been the major hindrance in performance for gold equities versus gold over the last two years. However, due to the global slowdown in the overall mining business witnessed so far in 2012, we see some evidence that capital costs may have peaked and labor inflation may be moderating on a global basis. Should this indeed be an inflection point in costs for the gold miners, we would expect gold equities to outperform gold going forward.
- Francisco Blanch, head of commodities research for Bank of America Merrill Lynch, forecasts that the gold price will rise to $2,000 an ounce by the end of 2013.
- David Rosenberg of Gluskin Sheff noted that investors have $7 trillion of cash currently sitting in retail money market funds and banking sector saving deposits. Rosenberg suggests exposure to precious metals and well-valued mining stocks for investors with long time horizons in this highly-charged reflationary global policy backdrop.
- Rosenberg further suggests that what the Fed really did this week was move from a mid-2015 time stamp to an end-of-2018 time stamp. “Six more years of financial repression. Get used to it.” Rosenberg went on to say, “If our assumptions are anywhere in the ballpark, the Fed’s balance sheet expands … to nearly $9 trillion or practically 50 percent of GDP by the time the unemployment rate gets to the 6.5 percent Holy Grail. At that point, Holy Grail is likely to turn into ‘Holy Cow’ as the Fed embarks on the inevitable process of unwinding all of this monetary largesse.”
- In Ghana, the incumbent president was reelected to office this week. In 2011, the incumbent Government of Ghana proposed increasing its corporate tax rate on miners to 35 percent from 25 percent, a uniform regime for capital allowance of 20 percent for five years of mining, and applying a separate 10 percent tax on windfall profits. The corporate tax increase and capital allowance came to pass, but the proposed windfall tax was deferred. A reintroduction of this bill in parliament could negatively impact the outlook on gold miners and developers with exposure to the country.
- Ivory Coast lawmakers voted unanimously to put a windfall profits tax on gold miners. Tax rates of 9 percent to 19 percent will be applied on profits above a benchmark cash cost set at $615 per ounce. Actual production costs to produce an ounce of gold are closer to $1,300 per ounce.
- Crude oil futures closed the week up 1 percent from last Friday after the Federal Reserve announced a fresh round of monetary stimulus and the International Energy Agency revised its 2013 global oil demand forecast upward to 90.5 million barrels per day.
- VLCC crude oil tanker rates on the benchmark Arabian Gulf to Far East route have risen briskly this week. On a day-rate basis, this equates to a current time charter equivalent (TCE) of about $21,000 per day, up from $5,000 per day last week. While this is a dramatic rise in a short time, we note this is still just barely above cash flow breakeven costs for most owners.
- Farmland values in Iowa, the biggest U.S. grower of corn and soybeans, surged 24 percent to the highest ever in 2012, according to an Iowa State University survey of real-estate transactions. The value of agricultural land rose to an average of $8,296 an acre in the year ended November 1, up from a previous all-time high of $6,708 in 2011, reported the university in Ames, Iowa. This is the third-consecutive year that values have increased more than 15 percent, and this is the first time county averages have reached levels over $10,000, survey results showed.
- Natural gas futures have dropped 15 percent since hitting a recent high of $3.901 on November 23 as mild winter weather has weakened demand.
- In a press release following the conclusion of its December 12 meeting, OPEC announced that it will keep production targets unchanged at 30 million barrels per day. The communiqué noted that worries over the global economy persist, and world oil demand growth is likely to be more than offset by non-OPEC supply, saying that the demand for OPEC crude would fall to 29.7 million barrels per day in 2013.
- Wheat declined 5 percent this week to the lowest level in five months on concern that India, the world’s second-largest grower, may ship more of the grain from government stockpiles, intensifying competition among exporters.
- The Fed announced a fresh round of monetary stimulus. As expected, the Federal Open Market Committee (FOMC) replaced “operation twist” with $45 billion of nominal Treasury purchases with “an average duration of approximately 9 years.” In a note published this week, Deutsche Bank economists expect this open-ended QE to last through the third quarter of 2013. In an unprecedented move, the Fed indicated that interest rates would remain near zero until the unemployment rate drops to at least 6.5 percent and as long as it does not forecast inflation above 2.5 percent. This is seen as positive for equities, negative for the dollar and consequently constructive for commodities.
- A steep decline in steel inventories may lead to stronger-than-usual restocking in the New Year, says Reuters. Data suggest that inventories in some Chinese cities have fallen by up to half as traders avoided restocking due to weak demand during the year.
- Quebec Premier Pauline Marois said her government will meet mining companies in the next three months to gather input as it seeks to raise royalty taxes on mining companies to help generate revenue. “We will have a discussion probably in February or March” with mining companies, Marois said in an interview at Bloomberg’s headquarters in New York. “We want to raise more revenues from royalties, but we don’t want to kill the industry,” she added.
- Fitch said that Western European steel output is unlikely to recover in 2013 due to depressed demand levels across the eurozone. Steel volumes will probably fall by up to 3 percent, Fitch Ratings believes, putting pressure on producers' profitability and free cash flow generation. However, profit margins may be supported by the falling cost of raw materials. Construction activity is the weakest area while demand from automotive manufacturers and mechanical engineering may increase towards the end of 2013. This lackluster demand means prices are likely to remain flat through the year.
- Australian high-quality hard coking coal prices may drop by 19 percent to average $171 per ton free on board in 2013 compared to $210 per ton this year, Platts reported citing a report by Australia’s Bureau of Resources & Energy Economics. The price-drop forecast comes as supply increases to outpace the outlook for steel production growth led by China, India and other emerging markets, the agency said.
- China reported economic data for November. Retail sales were up 13.6 percent from 13.5 percent and industrial production was up 10.1 percent from 9.6 percent in October. Electricity production was 7.9 percent, up from 6.4 percent a month earlier. CPI inflation ticked up to 2.0 percent, lower than the estimate.
- The HSBC China Flash PMI was 50.9 in December versus the estimated 50.8. It was 50.5 in November. PMI above 50 indicates industrial activities are expanding. The number confirms a continued recovery in China primarily due to domestic fiscal spending in infrastructure and construction.
- China’s November fixed asset investment growth stayed stable at 20.7 percent in the January-November period, due to slower growth in railway equipment and flat growth in manufacturing investments, but faster growth in property and railway infrastructure investments.
- After five months of year-over-year declines, China’s monthly railway freight transport turnover turned into growth at 2.4 percent in November. Monthly passenger turnover growth accelerated to 6.5 percent in November from 2.1 percent in October as more new lines started operations.
- China’s passenger vehicle wholesale was up 10.3 percent in November from 5.9 percent in October, while retail sales were up 8.75 percent. In particular, SUV sales were up 18.02 percent year-over-year. BMW sales were up 62 percent year-to-date.
- China’s system-wide credit growth edged up further in November to 20.2 percent from 20.1 percent in October. Such robust credit growth lends support to GDP growth.
- The China Securities Regulatory Commission has halted IPO approvals for two months, and will probably extend the ban until at least February 2013 as it tries to underpin the market, the South China Morning Post reported. The Shanghai Composite Index was up 4.32 percent on Friday, successfully breaking out from its 150-day moving average.
- China’s November exports were up 2.9 percent, lower than the market consensus of 9 percent.
- China’s M2 money supply growth slowed to 13.9 percent in November from 14.1 percent in October. New bank loans rose to RMB 523 billion from RMB 505 billion in October. Industry analysts think the lower M2 growth rate and new bank loans were due to increasing issuance of corporate bonds, which cost less than bank loans.
- Hong Kong’s basic power tariff hike was less than 1 percent, lower than the market’s expectation of 2 percent.
- The Bank of Korea left its policy rate unchanged at 2.75 percent after two 25-basis point cuts in July and October. Economic growth momentum remains weak going into the fourth quarter of the year, but investors are expecting a modest growth recovery in the coming quarters.
- The chart above shows HSBC China flash PMI is 50.9 after rising for four months. The upbeat flash manufacturing PMI suggests China’s recovery is continuing in the last few weeks of 2012. Although new export orders fell below 50, and, for that matter, the inventories index rose from 48.8 to 49.7, we expect the recovery to continue in the first half of 2013 due to continued domestic fiscal spending on infrastructure and urbanization. Investors will watch this weekend’s China Central Economic Working Conference for clues of policy directions.
- Shanghai is encouraging couples who are both single children to have a second baby, the Xinhua News Agency reported this week, citing the municipality’s population and family planning committee. There are also talks that China will abandon the one-child policy soon, which will allow a balanced demographic age mix and support economic growth.
- November inflation in Russia was at 0.3 percent, half the expected number, paving the way for the central bank to reverse monetary policy to ease and to relieve funding pressure on the banks.
- The Bank of Indonesia kept the benchmark interest rate unchanged at 5.75 percent this week. With increasing current account deficits, the market expects the central bank to tighten monetary policy next year.
- China’s disappointing November export growth indicates China still faces challenging external markets, which is a drag on economic growth. New export orders in the HSBC December China flash PMI also showed a contraction to 49.3 from 52.1 in November.
- New power generation capacity will put pressure on non-regulated power prices, affecting profitability of power generation companies in Russia, where demand growth for power is flat to negative.
(c) US Global Investors