October 2018 IssueLong scroll reading

Consequences – Unintended or Not?

By Edward A. Studzinski

“The danger is not that a particular class is unfit to govern.  Every class is unfit to govern.”

          John Emerich Edward Dalberg Acton, aka Lord Acton, “Letter to Mary Gladstone” (24 April 1881)

The continued shrinking of liquidity has been a continued concern of mine.  We are at a point where the danger signals are again blinking, except the danger will come not from the direction anticipated.

Years ago, after the dot.com craze and then the Crash of 2008, one of my former colleagues had become quite focused on limiting the size of individual positions in his funds to those equities where the entire position could be exited in say, five days trading volume.  Note here that trades used to settle after five days as well.  The result was that the market capitalization of those issues that he held drifted steadily upwards to the point where his ownership was mostly of large cap or mega cap securities.  It is worth observing that the reputation of the firm had been made as small cap and mid cap value investors.  The reputation of the portfolio manager in question, as an analyst, had been made again in mid cap value investments.  But, the change was made to benefit and protect the firm’s investors, and it served its purpose during those periods.

Fast forward to today, where passive investing as well as exchange traded funds have taken dramatic market share from active investors.  As passive investors, the turnover in the portfolios is minimal.  Transactions take place to deal with withdrawals or with changes to the benchmark indices.  Now suppose the trend or shift to passive continues, and the number of active managers continues to shrink.  First go those with poorer results.  Then we proceed to eliminate the remainder in terms of quality of performance.  If this continues unabated, the active manager pool shrinks so that there is only one last active manager standing, in which case there is no one left to trade with.  Or perhaps there are two left, so they can trade with each other.  Liquidity of course becomes non-existent.  And then the performance of the active universe of managers as a whole becomes the average of the two, which will be nothing to write home about.  The only way out of this trap is for active managers to shift to multi asset class portfolios, AND, for cash to be introduced as an alternative asset. 

Jack Bogle famously warned, “If everybody indexed, the only word you could use is chaos, catastrophe,” because there would be no active managers to set the prices for stocks. An equally troubling question: who will buy when the markets fall and the indexes automatically sell? Where would the liquidity arise? ds

To the extent the above appears illogical, let me suggest this.  People have, especially at the direction of their advisors or consultants, placed a higher percentage of their equity investments in large cap, easily benchmarked investments.  Those portfolios are highly correlated to the germane index, and the argument is that they are highly liquid.  At the same time, uncorrelated small cap and micro cap portfolios are avoided as too risky because of their illiquidity.  My observation is this – those large cap, correlated portfolios are far more risky than they appear to be, because their true liquidity is much less than you might anticipate notwithstanding their reported market capitalization.  Rather, there is an increasing danger of an absence of bids for those issues in any major market panic or dislocation.  Consider this in your thoughts about portfolio asset allocation accordingly.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.