Stocktake: CRH investors gain at expense of index funds

Fund managers still cautious, changes at Apple, and was Bill Miller just lucky?

CRH shares hit nine-year highs last week on speculation the firm will soon be added to the Euro Stoxx 50 index – a development that should be noted by index investors, as well as CRH shareholders.

Inclusion forces index-tracking funds to buy shares. Anticipating this demand, many investors buy shares in advance; consequently, shares typically rise as the index inclusion approaches and then give up some of their gains in the days following the announcement.

The losers are the index funds forced to buy shares at the higher price. Hedge fund Winton Capital Management’s analysis of the 1990-2011 period indicates this costs index funds up to 0.27 percentage points annually. That may sound insubstantial, but it is two or three times the annual fee charged by the cheapest funds.

Indexers are not powerless. Some buy shares before inclusion announcements, but this increases tracking error – the difference between fund returns and benchmark returns.


Last week’s bounce is good news for CRH investors, but ordinary index investors will end up paying the price.

Fund managers still cautious towards stocks

Equities may be rising but there’s precious little irrational exuberance, judging by Merrill Lynch’s latest fund manager survey.

Cash levels, which hit a 15-year high of 5.8 per cent in July, have dipped to 5.4 per cent, but that remains very high by historical standards. Similarly, equity allocations remain well below traditional levels. Despite a furious global rally, sentiment has barely budged since February, and this defensive positioning suggests potential for further market gains.

Contrarians will be less keen on the US and emerging markets (EM), however. EM allocations, which hit their second-lowest level in history in January, are now at their highest since September 2014. Similarly, managers had underweighted the US throughout 2015-16, during which time the region outperformed, but US allocations are now at a 20-month high. They may go higher, notes Fat Pitch blogger Urban Carmel, “but the tailwind for the US due to excessive bearish sentiment has mostly passed”.

Europe, however, is unfashionable. Managers had wrongly overweighed European stocks over the last 18 months but allocations have dipped of late. They may dip much further – Merrill’s survey indicates apathy rather than revulsion – but investors’ loss of belief will cheer contrarians betting on an end to European underperformance.

The rise and fall of Bill Miller

Fund management firm Legg Mason has parted ways with Bill Miller, the iconic stock-picker who spectacularly fell from grace following catastrophic bets during the 2008 financial crisis.

Long regarded as an all-time investment great, Miller beat the S&P 500 every year between 1991 and 2005. The odds of such a run, an analyst once calculated, were 372,529 to 1. However, the following decade was traumatic; Miller's main fund more than halved in 2008 alone.

Did Miller lose his touch? A more plausible explanation is that his luck ran out. In The Drunkard's Walk, physicist Leonard Mlodinow notes that during Miller's glory years, there were more than 30 12-month periods where he underperformed indices; they just happened not to be calendar years.

As regards continually beating the market, Mlodinow reframed the question: over a 40-year period, what are the odds one fund manager will outperform for 15 straight years? About 75 per cent, he calculated.

Far from being a brilliant investor, Bill Miller may just have been a very lucky one.

Past performance no guide to future returns

Miller’s downfall shows past performance is no guarantee of future returns, as is also made clear in S&P Dow Jones Indices’ latest analysis of fund managers.

S&P found just 7.3 per cent of the top-performing funds in the first quarter of 2014 remained in the top quartile in March 2016. Looking at the top half of 2012 performers, just 6 per cent stayed in the top half of funds in each of the next four years – just below levels one expects based on chance.

“Due to either force of habit or conviction, investors and advisors consider past performance and related metrics to be important factors in fund selection,” said S&P. Only a lucky few, however, can remain at the top.

Apple’s changing shareholder base

Filings last week revealed George Soros and David Einhorn had, like fellow hedge fund managers Carl Icahn and David Tepper in the previous quarter, reduced their stakes in Apple. In contrast, Warren Buffett upped his stake by 55 per cent to $1.5 billion.

Fast money types will note Apple’s earnings, which had grown by 29 per cent annually over the last five years, are expected to suffer a double-digit decline in 2016, while a modest 7.8 increase is pencilled in for 2017. Value investors such as Buffett, however, will be attracted to a stock that has traded on 11 times earnings in recent months, especially when the S&P 500 trades on 19 times trailing earnings.

Apple’s changing shareholder base highlights a fundamental shift: this long-time high-flyer is now an old-fashioned value stock.