The End of Passive Investment - Swisstrust
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The End of Passive Investment
July 2020
Passive investment strategies forego active management of a portfolio in favor of buying and
holding exchange traded funds (ETF) that track an index. For example, rather than selecting a
portfolio of stocks from the 500 stocks that make up the S&P 500 index, an investor would
purchase an ETF that tracked all these stocks as closely as possible. In essence, it is akin to
purchasing shares in a fund that contained all 500 stocks that make up the S&P 500 index.
ETFs: What Goes Up…?
It is a very cost-effective strategy. ETFs have a very light “load”, i.e. the administrative costs of
such a fund are very low. There is no need to pay an asset manager to analyze companies and
to make informed decisions about which companies should be included in the portfolio. These
decisions have already been made by those who put the index together, based on the specific
criteria they used. The stocks in the index may have been selected based on volume, free float,
or price, and they may be volume-weighted or price-weighted. It matters little that the investor
probably has no idea what these terms mean or how they affect his “portfolio”. Investors just go
with whatever makes up the index, a very inexpensive way of investing. During the long bull
market, when stocks and the indices derived from these stocks performed well, it was also a
very profitable one. However, since the markets collapsed due to the Coronavirus crisis, this is
no longer the case. While the ETFs tracked the stock market on the way up, they must also track
it on the way down. Outperformance relative to the index is not possible under a passive
investment strategy.
The Coronavirus crisis has led to a clear bifurcation in the stock market. On the one hand are
those stocks of companies that were relatively well able to weather the storm. These are
companies that are not highly exposed to sectors that had to be shut down to control the spread
of the virus, that have strong balance sheets providing for sufficient reserves to keep operating,
or that are scalable, not only on the way up but also on the way down.
Winners & Losers
Jim Cramer, the MSNBC commentator, has put together a list of stocks that meet these criteria.
It contains tech heavyweights like Amazon and Google, specialty stocks like the video
conferencing company Zoom, suppliers of cleaning and disinfectant products such as Procter
and Gamble, etc. You get the picture. There are stocks that, because of their business and their
balance sheets, should be okay despite the virus pandemic.
On the other hand, there are companies that are clearly suffering. First and foremost, they
include the cruise lines. Norwegian cruise lines, for example, crashed from about 60 Dollars in
early February to less than 10 Dollars by mid-March. Carnival also lost more than eighty percent
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UID CHE-101.131.556 MWSTover the same time period. Airlines suffered a similar fate. For example, equities in Delta and
American airlines lost two-thirds of their value. Stocks of companies in the hospitality sector,
such as Hyatt or Hilton, fared equally poorly, losing between two thirds and three-quarters of
their value.
Additionally, many brick and mortar retailers were already in trouble before the pandemic hit.
Sears was in a Chapter 11 bankruptcy since October 15, 2018. JC Penney, another other iconic
US retailer, filed for bankruptcy on May 16, 2020, following J Crew (May 4), Neiman Marcus
(May 7), and Stage Stores (May 10). Macy’s is closing 125 stores, and many smaller retailers
have also had to close their doors. For this bloodbath, there is still no end in sight.
Did investors in S&P 500 ETFs realize that their portfolio contained equities in all these
companies? Cruise lines, airlines, and brick and mortar retailers all feature prominently in the
S&P index. They are the primary culprits when it comes to the question of why the S&P 500
index lost about a third of its value in the space of a few weeks. However, the fact that the index
lost “only” a third shows that stocks other than the disaster stocks referred to above actually
held up quite well in relative terms. If one had put together a portfolio that included stocks well
prepared for the pandemic storm, such as the Jim Cramer portfolio referred to above, and left
out or even shorted the stocks that were obvious candidates for a major correction (cruise lines,
airlines, hotels, brick and mortar retailers) one could easily have outperformed the S&P 500
index. The following graph illustrates that point:
S&P500 Index and Selected Stocks
January 1 through May 31, 2020
160.00
140.00
120.00
100.00
80.00
60.00
40.00
20.00
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18-02-20
31-12-19
07-01-20
14-01-20
21-01-20
28-01-20
04-02-20
11-02-20
25-02-20
03-03-20
10-03-20
17-03-20
24-03-20
31-03-20
07-04-20
14-04-20
21-04-20
28-04-20
05-05-20
12-05-20
19-05-20
26-05-20
SPX AMZN MSFT CCL AAL M MDLZ
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UID CHE-101.131.556 MWSTThe heavy blue line from the previous graph is the S&P 500 Index. Among the 500 stocks making
up that index are the six examples included in the same graph. As can be seen, there were a
number of stocks that performed very badly during this crisis. They include cruise lines (Carnival:
CCL), airlines (American: AAL), and brick and mortar retail (Macy’s: M). These companies simply
serve as examples, and other firms in these sectors would paint a very similar picture. We could
also have included any other cruise- or airline and any other retailer. It would simply have
crowded the graph without providing any more information.
At the other extreme are stocks that predictably did relatively well during the pandemic. They
include online retailers (Amazon: AMZN), large-cap technology companies (Microsoft: M), and
boring, stable consumer stocks such as Mondelez (MDLZ). Again, we could have selected
companies such as Google, Pepsi, or E-bay for similar results. Including on-line conferencing
companies such as Zoom, however, would have busted the graph. Zoom gained 163 percent
over the period shown here.
It does not take a genius to have predicted in February which sectors would suffer most from
the shutdowns necessary to control the virus. There was an obvious group of equities investors
should have avoided starting in February 2020. If you also realized that OPEC was not going to
come to an agreement on production cuts, a fact also known in February, you could have added
the oil sector to the group investors should stay away from. Thinking this through and making
the required adjustments to a portfolio is what active asset managers are paid to do.
The Swiss Market
In European markets in general, and in the Swiss market in particular, we observe the same
effects. Pharmaceutical companies such as Roche fared quite well. Lonza, a contract producer
of vaccines, also held up well. On the other hand, Swiss Re, reinsuring other insurance
companies, took a steep tumble. The graph on the following page shows the SMI Index year-to-
date through the end of May as well as a few selected SMI stocks.
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UID CHE-101.131.556 MWSTSMI Index and Selected Swiss Stocks
January 1, 2020 through May 31, 2020
140.00
120.00
100.00
80.00
60.00
40.00
30-12-19
06-01-20
13-01-20
20-01-20
27-01-20
03-02-20
10-02-20
17-02-20
24-02-20
02-03-20
09-03-20
16-03-20
23-03-20
30-03-20
06-04-20
13-04-20
20-04-20
27-04-20
04-05-20
11-05-20
18-05-20
25-05-20
SMI ROG LONN ALC UHR SREN CFR
The heavy blue line is the SMI Index. Obviously, here too, some stocks clearly outperformed the
index (Roche: ROG, Lonza: LONN, Alcon: ALC) while some obviously underperformed (Swatch:
UHR, Compagnie Financière Richemont: CFR, and Swiss Reinsurance: SREN). Another obvious
candidate to suffer from the pandemic is the Zurich airport; shares had lost roughly half of their
value by mid-March, though it has not been included here because it is not part of the index.
Fortunately, the Swiss market index does not include any airlines, cruise lines, or brick and
mortar retailers that fared particularly badly throughout the world.
Of course, there are specific issues with each of these companies highlighted in the graph.
Alcon, for example, provides eyecare products and equipment used in eye care surgery. These
surgeries are often elective, and hospitals under stress postponed virtually all elective surgeries
at the height of the pandemic. Accordingly, Alcon suffered in line with the SMI index during
February and early March, but since restrictions during the pandemic have lessened
considerably in the last few weeks, Alcon is faced with pent-up demand and is recovering nicely.
Similar special circumstances can probably be found for every company in the SMI. Overall,
however, the fact remains: There are sectors and companies that we would expect to suffer
more than most in a pandemic. They are often part of the index. Investing only in the index
means investing in these companies as well, something one would not want to do. On the other
hand, we could readily predict which companies would be less impacted. Direct investments in
these companies will yield better results than investing in the index.
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UID CHE-101.131.556 MWSTLooking Ahead
Going forward, we still find ourselves in a TINA (There Is No Alternative … to stocks) environment.
Alternatives to equities provide no return or even negative returns as is the case for some
government bonds. Stocks are still the only game in town for investors seeking a return on their
investments. But we must be smart about which stocks to invest in and which stocks to avoid.
It is unlikely that we will enjoy a “V-shaped” recovery, i.e. that the economy will rebound very
quickly. Rather, I suspect that the recovery will happen, but only gradually. This means that the
stocks hit very hard in the pandemic will take quite some time to recover once we are able to
return to some level of normalcy.
I therefore fear that many of the stocks that lost heavily during the pandemic remain
untouchable. Even if the pandemic subsides it will be a long time before people start to travel
again. Airlines and cruise lines will face massively shrinking demand. The same goes for the
hospitality sector, especially for the parts that depend on tourism. I would want to stay away
from these stocks. Yes, they can be found at very low prices, but, naturally, there is often good
reason for these cheap prices.
On the other hand, I believe that many companies have come to realize that working from home,
at least some of the time, is not all that bad. Companies that make this possible should do well
going forward. I also suspect that one of the consequences in the medium term will be weaker
demand for office space in city centers. I am skeptical of companies that own a lot of such real
estate, including the brick and mortar retailers.
I continue to be optimistic about the prospects for the health care sector. The parts that depend
to some degree on elective surgery procedures will recover relatively quickly as they face pent-
up demand. There will be more than one pharma company releasing a COVID vaccine at some
time in 2021. Demand will be huge, but governments will be under a lot of pressure to keep a
lid on prices. Nevertheless, the pandemic has demonstrated to the extent to which today’s
society depends on a strong health care sector.
All in all, I am cautiously optimistic, at least for some sectors of the economy and the stocks of
companies within these sectors.
July 2020 / KOH
P.S.: Hurray! I did it! I managed to write an entire commentary without once mentioning Donald
Trump. I set out with the firm intent to avoid the T word - if at all possible. I succeeded. I hope
you appreciate the effort.
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