I learned a lot from my first business dinner in the investment industry years ago. Number one, define your terms. Before we left our Director of Research told us we could only purchase one bottle of wine for the table. So the senior member of our team ordered a magnum. The second thing I learned is that ordering off the menu, if you know the wait staff, is a great thing to do. I had the best hash browns in my life as a result. Does investing off-menu, meaning off-index, investing offer the same tasty results?
Usually it does. Countless studies show that underfollowed and under-appreciated securities often outperform their more followed and “loved” rivals. At the same token with a nearly worldwide zero to very low interest rate policy going on as far as the eye also puts a premium on growth and/or yield—making momentum investing a viable strategy. Plus good portion of those momentum securities are in an index or an ETF because they exhibit those growth/yield characteristics—along with ample liquidity.
Therefore we can plausibly assume that as long as zero or abnormally low interest rate policy holds, and investors believe that policy will continue for the investing horizon that buying these securities on a dip is a good strategy. Indeed, the performance of momentum strategies during past few years has given credence to that notion. In addition one also can reasonably assume with the growth of index/ETF investing that as more money gravitates toward these securities, and as they grow in proportion in the index/ETF, that buying momentum stocks that are in one or both of those vehicles becomes self-perpetuating. At least as long as the investment thesis holds on those individual securities in the index/ETF—and as long as Mr. Market believes that the Fed Calvary will come to the rescue each time Mr. Market stubs his toe. Or as long as interest rates hold to a “manageable” level. How long will this continue? Your guess is as good as mine.
So where does that leave those securities that are not in an index or an ETF (or at least not in a highly liquid ETF) especially those that are not especially liquid compared to their peers at this point in time? Sometimes it feels as though that the psychological hurdle rate of those stocks has risen. Indeed, I find myself needing either some very strong and visible upcoming catalyst or some degree of beginning technical momentum to get myself interested in off-index and off-ETF names compared to a couple of years ago. This goes against my contrarian and mean-reversion heart.
Finally, I also believe that eventually the rules of supply and demand and valuation do take over and this index/ETF oriented strategy will eventually end—most likely in tears when everyone rushes for the exits at once. In the meantime will I continue to explore and add off-index/ETF names to my portfolios? Of course, as it is nearly impossible to beat the market consistently without these names, and no one wants to be a “closet indexer”. But as long as there is so much liquidity and demand towards index/ETF names the hurdle and discount rate I give to off index/ETF names will necessarily be higher than what I would normally, and would prefer to, apply.
Therefore, lets pop open a magnum and enjoy the low interest rates, liquidity and good times while it lasts.