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The End of Indexing?

The End of Indexing?

The investment world is changing. The lessons learned in the stupendous global bull market of the last 40 years will serve us very poorly in the years ahead.

Rob Arnott


A few years ago, when Harriman House agreed to publish my first book, they only had one concern – they didn’t like the title (can’t even remember what I had suggested). “Too boring”, they said. “It won’t sell any books”. I took up the challenge and ended up with The End of Indexing.

Did I mean to suggest that nobody will ever invest passively again? Not at all. What I tried to point out with that title was that we were about to enter an environment that is far less suited to passive investing; that, in the current environment, active investors stand a much better chance of outperforming passive investors than they did in the “stupendous global bull market of the last 40 years” (Rob Arnott’s words – not mine).

As I have made you aware at least a couple of times already, we are about to launch The ARP Megatrend Fund. If everything goes to plan, it will go live as an Alternative Investment Fund in Dublin sometime in September. Today, I will share with you some work conducted recently by one of our analysts, and I will demonstrate that The End of Indexing may in fact not be far away.

How we invest

Over the past 15 months, we have been managing a portfolio we call The Megatrend Portfolio. This portfolio is essentially the predecessor to The Megatrend Fund. Only one thing of significance will be different in the fund. Whereas The Megatrend Portfolio can only invest in financial instruments listed on a US exchange, The Megatrend Fund can invest worldwide. This is a substantial improvement over existing conditions.

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As you are probably aware, our investment strategy is tied up with the seven megatrends we have identified. In each and every case, we have found a number of investment themes that can be linked to at least one but often a few of those megatrends.

Example: Climate Change – probably the most recognisable of all ‘our’ seven megatrends. How do you invest in Climate Change?  One of the investment themes associated with Climate Change is a theme we call Electrification of Everything, and that theme has led us to an investment opportunity we call Green Metals, i.e. we invest in metals that stand to benefit from the green transition.

If I take a quick look across the seven megatrends, I can tell you that we have, in all instances, identified at least three investment themes. In the case of Climate Change, we are up to no less than seven. In no particular order, they are:

- Out-of-Control Public Deficits.

- The Digital Revolution.

- Electrification of Everything.

- The Death of Fossil Fuels.

- Running Out of Freshwater.

- Extreme Weather Patterns.

- The Race to +2ºC.

On the basis of those themes, we construct baskets of investment opportunities, e.g. Green Metals. We currently have a total of 14 baskets in the Megatrend Portfolio, and we can, in most instances, measure the success of our active investment style by comparing our return to various passive ETFs and/or indices that pursue/track the same strategy.

Our results  

Now to the interesting part. How have we performed so far? One could argue that we should be satisfied, if we can outperform our benchmark, the MSCI World Index, but that is only half a victory. If investors could do even better by investing in a portfolio of ETFs and/or index funds that pursue/track the same strategy, my argument that passive investing is yesterday’s story is rather hollow. Therefore, our aim is not only to do at least as well as the MSCI World Index but also to outperform the relevant basket benchmarks.

I would probably put you to sleep if I were to show you all 14 baskets, so allow me to select only a few. Let’s begin with the biggest basket of them all – the uranium basket – which accounts for 13-14% of the Megatrend Portfolio at present. It has had a meaningful impact on both absolute and on risk-adjusted returns, not only because it is the largest basket in the portfolio but also because of its high equity beta.

As you can see in Exhibit 1 below, our uranium basket has not only performed well in absolute terms. It has also significantly outperformed its two most obvious uranium benchmarks – VanEck’s Uranium + Nuclear Energy ETF (NLR) and the Global X Uranium ETF (URA) – and the reason is relative straightforward. Whereas both ETFs are market cap weighted, the uranium basket is not, and exceptional performance in a couple of small cap names in the Megatrend Portfolio has made a massive difference.

Exhibit 1: The Uranium Basket in the Megatrend Portfolio vs. VanEck Uranium + Nuclear Energy ETF (NLR) & Global X Uranium ETF (URA)
Source: Absolute Return Partners

Our renewables basket has also delivered solid performance – maybe not in absolute terms but, relative to its benchmarks, the performance has been outstanding (Exhibit 2).  The reason here is probably idiosyncratic risk. Our renewables basket is quite concentrated, and we have benefitted from a small handful of  winners that have driven the basket’s performance.

Idiosyncratic risk can obviously work both ways, and it doesn’t always work in one’s favour, but that is effectively what you pay for in actively managed funds – the ability to select the winners.

Exhibit 2: The Renewables Basket in the Megatrend Portfolio vs. Global X Renew. Energy ETF (RNRG) and iShares Global Clean Energy ETF (ICLN)
Source: Absolute Return Partners

Our greatest success story comes from Asia. (You may wonder how we can invest in Asia if we can only buy equities listed on a US exchange. The answer is simple – ADRs.) Rise of the East is one of the seven megatrends we adhere to, and we have invested in companies that stand to benefit from fast economic growth and rising living standards throughout the region.  

I deliberately say “throughout the region”, as we have some serious concerns about China over the short to medium term. However, there is much more to the Rise of the East story than China. Therefore, it is all about structuring the portfolio correctly – an option not available to ETFs. You can see our results in Exhibit 3.

Exhibit 3: The Asian Alpha Basket in the Megatrend Portfolio vs. MSCI AC Asia
Source: Absolute Return Partners

Allow me to finish with the worst performing basket in the Megatrend Portfolio. During the banking crisis in California in January, we took the view that Japanese banks were not likely to be as affected by the crisis as the collapse in their share price would suggest.  As you can see in Exhibit 4, we underperformed our benchmark for quite a while and have only recently moved into positive territory.

Exhibit 4: Japanese Banks Basket in the Megatrend Portfolio vs. iShares MSCI Japan ETF (EWI)
Source: Absolute Return Partners

A few caveats

As already mentioned, we currently have 14 baskets in the Megatrend Portfolio. Therefore, I should be able to show you 14 comparative charts, and I have only shown four. Why? I am certainly not trying to hide anything, but the internal research project behind this paper has only been able to identify nine relevant benchmarks – not 14.

Another reason, in one or two instances, is the lack of statistical significance. If a basket was only created recently (as in the case of AI), even if we have outperformed our benchmark, is it statistically significant? I have deleted those where I felt uncomfortable on those grounds.

And then, of course, my desire not to bombard you unnecessarily led to a few further deletions, but I can assure you that the pattern is consistent. That said, in some instances, the outperformance is substantial (e.g. healthcare), while in others it is much more modest (e.g. water).

Why it is becoming easier to be an active investor

I landed my first job in finance in early 1984, having just graduated, so I have been involved in financial markets for nearly 40 years.  In the context of active vs. passive investing, that becomes highly relevant, hence the mention.  

Over the years, I have learnt quite a few things when it comes to investing – particularly what not to do (!), and one thing stands out.  In a raving bull market, it is bloody hard to beat the index, i.e. investing passively makes perfect sense.  However, when the tide turns, active portfolio management becomes a great deal easier.

Now, if you have read The End of Indexing and/or followed my work at Absolute Return Partners, you will know that I am of the opinion that, from an investment point-of-view, the next ten years won’t be as fruitful as the last 40.  Quite simply, the great bull market is over!  That doesn’t necessarily imply negative returns, but the days of leaning back on the sun lounger in the knowledge that your portfolio of ETFs will do the job are well and truly over.

Going forward, much more work needs to go into the decision process, if you want satisfactory returns. That is why I called my book The End of Indexing, and that is why I am writing this research paper.  Over the next decade, some years will be great for investors, but others will be terrible. And, when we open the book in August 2033, annualized 10-year returns on an indexed equity portfolio won’t be anywhere near what we have grown accustomed to over the last 40 years, I believe.

The ‘only’ good news from an investor’s point-of-view is that neither will management fees. The 2+20 model is dying, and the cost of active management is falling – to a degree that I can comfortable project that, not so many years from now, active management will not be meaningfully more expensive than the cost of holding a typical ETF.  At least, we will do our best to make that happen.

Niels C. Jensen

14 August 2023

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.