Everything in Moderation

by Seamus Sullivan, Smead Capital Management

Dear fellow investors,

By the time I began my career in the investment business in 2008, ETFs were already a well-established investment vehicle within the industry. Warren Buffet, as well as others, have touted the benefits of ETFs in relation to active mutual funds and hedge funds alike. Their reasoning was sound as usual. ETFs are liquid, simple to understand, have some tax advantages, and charge very low fees. Thanks to these attributes, investors could participate in the market while limiting their costs and, as a result, likely outperform most active funds, net of fees.

However, with the help of the Federal Reserve, we believe ETFs have increasingly contributed to greater illiquidity, volatility, index concentration, market inelasticity and other growing distortions within equity markets. As many know, ETFs are no longer the ~1% to 2% share of markets. Today, passive vehicles account for ~45% (of the US market).¹ They are also no longer the diversified and frictionless investments touted by the marketing material. For example, there is currently $1.9 trillion in net assets in large-cap domestic equity ETFs.² Where were those dollars invested in prior decades? The answer is glaringly evident when you look at the company weightings of the S&P 500 index. ETFs no longer mimic active investors in the aggregate; they are shaping the market through unhealthy concentration in only a few names due to their self-reinforcing nature.

Source: Bloomberg

We have used the chart above recently and believe it reflects the pressures EFTs have placed on indexes to address concentration issues. It’s also a great analogy to a riddle that Buffett has used before by Abraham Lincoln. “If you call a dog’s tail a leg, how many legs does it have? Four, because calling a tail a leg doesn’t make it one.” While we are not anticipating a market correction like the Global Financial Crisis, we are also not ruling it out. There are some parallels to our current market sentiment in terms of risk tolerance, investor complacency, valuations, and sector concentration that should be rather concerning. As the Fed continues to fight inflation and rates stay at these levels or rise, the market correction we had last year may have just been a precursor of things to come in this new market structure. The chart below shows the parallels we believe to be in place with 2008 and today’s market.

We are not the only ones voicing concerns regarding the impact ETFs are having on markets. In the last two years there has been growing analytical research showing that the initial premises of ETFs, increased liquidity, low friction, etc., have now begun to exceedingly influence market pricing even while applying relatively low volumes. For example, we (and most active managers) typically hold a percentage of our portfolio in cash. We believe this cash gives us optionality. It affords us the ability to invest in companies when their valuations become very attractive. It also allows us to meet potential redemptions without selling shares.

On the other end of the spectrum, ETFs typically carry almost no cash. For example, the Vanguard Total Market Index share classes hold about $1.6 trillion in assets but carry only ~$80 MILLION in cash (that’s 0.0005%!). When markets correct and people sell, the ETF space must sell shares and we are not aware of many active managers that can collectively meet even a fraction of the cash needed to soak up the dollar value of selling to restore order at extreme valuations.

Source: Federal Reserve of Boston

As active managers, we are inherently biased in our view of ETFs and their role in markets. But in aggregate, we believe ETFs are a necessary and helpful alternative to investors. If most active managers earned their fees by outperforming the markets, investors would not see the value in ETFs.

We have taken the view that our eight criteria for stock selection will guide us to invest in great companies at very favorable valuations allowing us to be able to compound our returns over the long term. We don’t particularly care what the theme of the month or year is. This style of investing, while superior over the long run, takes a balanced blend of humility, conviction in the research process and a willingness to take risks through a contrarian asset allocation. It’s easy to say but very hard to do. It is our willingness to follow our process and invest regardless of the conventional market view that we believe sets us apart from our peers (particularly ETFs). This is not just something we say, a quick glance at our portfolio demonstrates it’s what we do as well.

We view the makeup and valuations of today’s market as something to be looked at critically and we view the concentration with a high degree of apprehension.

Fear stock market failure,

Seamus Sullivan

¹ Investment Company Institute
² PWL Capital

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Seamus Sullivan, Senior Analyst, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

©2023 Smead Capital Management, Inc. All rights reserved.

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