Skewered by Skewness

“If it’s true that our species is alone in the universe, then I’d have to say the universe aimed rather low and settled for very little.” George Carlin, US Comedian.

We posted a tweet recently highlighting one of the major impediments Active Managers face in trying to beat the Markets, namely the impact of “Skewness” in the returns of Index constituents. (The original article is available in the EBI Repository here).

If this all sounds rather esoteric, it’s probably because it is- for Index investors at least. But it goes to the heart of why Active Managers repeatedly fail to beat the market, namely because missing out on just a few stocks can irreparably damage their performance relative to the Benchmark. It has not been a recent issue either- according to a recent article,

“A finance professor at Arizona State University, Hendrik Bessembinder, published a study that showed that a mere 0.33% of all companies that were a part of the U.S. stock market accounted for over half of the stock market return in the period between 1926 to 2015. In addition, only 30 stocks accounted for around one-third of the cumulative wealth created by the U.S. stock market over the same period. In other words, the average return generated by the market over time was driven by a very small number of high-flying stocks”.

More recently, up to April, Facebook, Amazon, Apple, Netflix and Google were responsible for 33% of the total market cap gains of the S&P 500 for 2017 so far, (amounting to over $1 trillion) with Apple alone accounting for 10% of the total according to one commentator; between March 1st and March 9th 2017, these five stocks, raised the value of the S&P 500 by $269 billion, at a time when the Index itself went nowhere, (and thus the rest of the Index, that is 495 separate stocks, FELL by the same cumulative amount).

Statistical analysis is primarily concerned with the distribution of data; whether it be the height of men in Birmingham, the number of goals scored per game in the Premier League or asset price returns, they tend to display a similar pattern that of a Bell Curve (or Normal ) distribution, with the mean, median and mode all at the top of the curve. I wrote tend for a reason however, as, in the case of asset returns, it can deviate from this norm, creating either a positive or a negative skew (see here for an explanation). In a Positively skewed distribution, the Mean is greater than the Median, due to the impact of a few individual data points (in this case stock returns), causing the distribution to have a long “left tail”- a small number of stocks that have done much better than the overall market. So, if an investor does not own at least some of these stocks, the last year or so has seen little in the way of return at best, and for some stocks, quite painful losses.

Why should this be ?

Economists have long believed/assumed that competition tends to equalise profits (and thus returns) as the least inefficient firms either improve or go out of business and so profit margins are competed away to the marginal costs of the enterprise. But this mode of thinking may be out of date, as we see the rise of “Superstar” firms, who are able to raise (and maintain) very high levels of productivity (and thus profitability). This might imply that the laggards are NOT catching up at all, and maybe are falling further behind in the race for success.

There are several possibilities;

1) Central Bank-inspired super- low interest rates mean that the weaker firms are not being “killed off” by creditors, fearful possibly of the negative PR that may follow, allowing the inefficient to survive when they otherwise would not. This competition makes for price wars, which nobody can ultimately win, but where most end up on the losing side, in the form of lower profits.

2) The lack of credit availability for smaller firms prevent (or at least impede) their expansion regardless of their efficiency.

3) Many profitable firms operate in “niches” which are too small to interest bigger companies. Thus, they survive, but cannot grow organically out of that niche to take on their bigger rivals. In any case, they may not want to: trying to take on Facebook may be an impossible task, as they have an entrenched advantage (as those who want to, already use their site- the so-called incumbency advantage)) and in any case their model is almost infinitely scalable. The use of Technology helps this enormously- Uber’s taxi business can be done literally anywhere once you have the algorithm set correctly for example.

If these are permanent changes to the landscape, (and it is still an IF), it will force us to re-think the conventional wisdom re: competition. Maybe, it actually creates monopolies, rather than destroying them; in turn, this generates stagnation as Companies generate more cash than they can spend. (Apple’s cash reserves currently stand at $250 billion- which is abut the same as that of Scotland’s GDP in 2013), whilst everyone else is overburdened with debt (states, individuals etc).

If so, we could continue to see small numbers of super-profitable firms dominating the landscape for years, much like the dinosaurs did millions of years ago, while we wait for the Comet to hit….

This highlights why market timing in general (and Active management in particular) is so hard as to be practically impossible. If a fund manager fails to hold even a tiny fraction of the market’s star performers, he/she will have virtually no chance of matching the gains achieved by the overall market. The idea of “Selling Winners” and Buying Losers” will not work either, as the winners just keep on winning…

Hence, Indexing is the only viable way to capture those returns, as you own everything via said Index. It’s cheaper too (markedly so in most cases)- maybe someone should set up a company dedicated to providing a set of model portfolios based on the evidence which overwhelmingly supports the case for Index investing; wait a minute…there may just be such a company already in existence…