Is Index Investing Turning Into A Bubble? This Billion Dollar Hedge Fund Thinks So (And Has The Data To Prove It)

The popularity of index funds and ETFs has risen exponentially since the financial crisis of 2008-2009, to the point where they now overshadow their actively managed counterparts on several fronts. This craze of taking money out of active funds and putting it into index funds has been driven by the reasoning that most fund managers fail to beat their respective benchmarks and that the fees one pays to put their money into an actively managed fund eats into the returns they do achieve. The allure of lower fees and better returns has in the past decade enticed a slew of investors, both retail and institutional, to pull their capital from active funds and park it into index funds and ETFs. One only needs to take a look at the ballooning AUMs of prominent index fund managers like BlackRock, Inc. (NYSE:BLK) and Vanguard Group to gauge the rapid pace of growth that index funds have seen in the last few years. However, this flight of capital from actively managed investment products to passive ones has come with its own share of systematic risks, something that the recent fourth quarter commentary published by Horizon Kinetics discusses in great detail.

Founded in 1985 by Murray Stahl, Horizon Kinetics is the parent company of New York-based Horizon Asset Management. The firm is known for adhering to a long-term, contrarian, fundamental value investment philosophy. In its latest market commentary, the firm devoted more than half of the document to arguing – along with facts and data- how ‘indexation’ is turning into an epidemic and could have a catastrophic outcome in the coming years. Though we can’t discuss in detail all the arguments the firm made against the indexation menace in one article,  there are a few major points from that commentary that investors interested in index funds should ponder over before taking the plunge.

One of the major arguments that the firm made is that the large amount of money that has flown into index funds over the past nine years has pushed up the prices of ‘index-centric securities’. During the same time, the outflow from actively managed funds has compelled fund managers to sell what they owned, thereby creating a valuation imbalance between securities that are indexed and those that are not. Stocks (generally large-caps) that are part of an index have become overvalued, while those that not have become undervalued. Horizon Kinetics cites the five largest index managers as having, in aggregate, $6.1 trillion of equity AUM. Meanwhile, according to Siblis Research, the float of the S&P 500 is $18.377 trillion. Hence, the top-five index fund managers alone account for 33% of the S&P 500’s total float.

Another concern Horizon Kinetics raises is that until now, the flow of money has been such that it was getting out of active funds and was being invested in index funds. As long as the money has been coming in, the securities held by index funds have been appreciating in value. However, there is a threshold of the money that can come out of actively managed funds and data suggests that we are soon to reach that threshold.

“We do not know where the tipping point is. But the minute the inflows slow meaningfully, whether that takes three years or ten, the index will no longer set the price, the ETFs will no longer be setting the prices of the winners. At that point, the baton passes to the active managers, and they will set the marginal price. The remaining active managers, the Mario Gabellis and David Einhorns of the world, do not pay 22x earnings for mature companies like Procter & Gamble, nor 128x estimated earnings for growth companies like Netflix or 37x for a retailer, like Under Armour. At that point, the equity market might suddenly become quite efficient.”

The very theory on which indexation relies upon (i.e. markets are efficient and that over the long-term the benchmark performs better than any fund manager who tries to beat it) goes for a toss when one realizes that it’s the actively managed funds who make the market efficient by valuing securities. When the AUM of actively managed funds dwindles, there won’t be enough fund managers to keep the markets efficient by valuing stocks and placing trades based on that valuation. This will result in a bubble where the benchmark index and ‘index-centric securities’ will keep on going up until the crowd keeps pouring money into them via index funds.

“Index investors and asset allocators are caught in a logic trap. They have no mechanism by which to decide when or how to withdraw. Once one accepts indexation as the methodology for investing, it is like a trapdoor, because whatever the returns happen to be, the S&P 500 orsome other index, is the benchmark. Any return the index gets is, by definition, the return you should get. There is no definition of an inadequate index return.”

In the rest of this article we’ll take a look at the five major holdings of Horizon Kinetics and will discuss what the fund had to say about them in its recent market commentary, beginning on the next page.

 Associated Capital Group Inc (NYSE:AC)

– Shares Held By Horizon Kinetics (as of September 30): 275,440

– Value of Holding (as of September 30): $9.77 Million

Although Horizon Kinetics owned only 275,440 shares of Associated Capital Group Inc (NYSE:AC) at the end of September, a recent regulatory filing by the firm shows that it owned 1.19 million class A shares or 19.4% of Associated Capital Group Inc (NYSE:AC)’s float as of December 31. Associated Capital Group was spun off from the parent company of Mario Gabelli‘s GAMCO Investors’ alternative investment management business and institutional research services operations in late-2015. Since then, its stock has appreciated by 31%. Associated Capital currently trades at a valuation of around $900 million, which is nearly a 10% discount to its net asset value of $1 billion.

The team at Horizon Kinetics thinks that as an asset manager with only $1.2 billion in AUM, Associated Capital Group can operate at a much larger scale if it manages to gather more assets. Moreover, because Associated Capital is a manager of alternative strategies, Horizon Kinetics is of the view that it will benefit from the ongoing trend among asset allocators to shift capital from conventional investments to alternative ones.

 Texas Pacific Land Trust (NYSE:TPL)

– Shares Held By Horizon Kinetics (as of September 30): 1.68 Million

– Value of Holding (as of September 30): $402.82 Million

Like it did with its stake in Associated Capital, Horizon Kinetics also increased its stake in Texas Pacific Land Trust (NYSE:TPL) during the final month of 2016, albeit marginally, by 17,666 shares. Texas Pacific Land Trust (NYSE:TPL) is Horizon Kinetics’ largest holding, amassing more than 15% and in some cases 20% of the value of some of the firm’s individual account strategies and fund formats. It is also one of the oldest holdings of the firm.

Despite the steep decline in crude oil prices, shares of Texas Pacific have appreciated by over 250% since the beginning of 2015, during which time its revenue from oil royalties and oil-related land leases and sales have risen by 150%. Moreover, the company has bought back 10% of its float since then. Apart from these factors, one of the main reasons that Horizon Kinetics is overweight the company is because Texas Pacific’s business and its stock are not co-related to the broader market, thereby providing both diversification and optionality. For its most recent quarter, Texas Pacific Land Trust reported EPS of $1.37 on total income of $17.57 million, compared to EPS of $1.10 on revenue of $14.72 million that it had reported for the same quarter of the previous year.

 DISH Network Corp (NASDAQ:DISH)

– Shares Held By Horizon Kinetics (as of September 30): 1.41 Million

– Value of Holding (as of September 30): $77.56 Million

Horizon Kinetics reduced its stake in DISH Network Corp (NASDAQ:DISH) by 5% during the third quarter. However, the firm remains optimistic about the company’s future prospects. The reason for its optimism does not come from DISH Network Corp (NASDAQ:DISH)’s primary business of providing satellite television, but rather its wireless spectrum.

In its market commentary, Horizon Kinetics argues that if one solely considers Dish Network’s primary business and takes into account that it lost 1.9% of its subscribers last year, the stock of the company trading at a forward P/E of 22.62 currently might look overvalued. But that’s not an accurate picture. The company has bought wireless spectrum licenses worth $15 billion since 2007, which are dormant as of now but could be hugely profitable in the future. Moreover, the firm estimates the present market value of those spectrum licenses (minus the debt of the company) to be around $45 billion, which is significantly higher than the company’s current market capitalization of $29.22 billion. On January 23, analysts at Morgan Stanley upgraded the stock to ‘Overweight’ from ‘Equal Weight’, while keeping their price target on it unchanged at $75.

 Wendys Co (NASDAQ:WEN)

– Shares Held By Horizon Kinetics (as of September 30): 12.28 Million

– Value of Holding (as of September 30): $132.69 Million

Wendys Co (NASDAQ:WEN) was another stock in which Horizon Kinetics reduced its stake by 5% during the third quarter. The firm first bought shares of Wendys Co (NASDAQ:WEN) in 2012 when they were trading at $6. Since then the stock has more than doubled and is up by 2.63% so far this year. Horizon Kinetics attributes a large part of those gains to the long-term transformation plan put forward by activist investors Nelson Peltz and Peter May in 2011-2012. However, the firm still considers the transformation “a work in progress” as the company has only upgraded 28% of its restaurants in North America versus a target of 60% by 2020.

In its market commentary, Horizon Kinetics argues that the substantial expenditure the company has spent on the remodeling of its stores masks the profitability improvement in the stores that have already been remodeled. Moreover, the firm thinks that these expenditures will decline sharply going forward, resulting in the free cash flow of the company rising substantially. Anticipating this increase in cash flow, Wendys has purchased 30% of its float in the past 18 months under its buyback program, which Horizon thinks “will be accretive on a per share basis in the future.”

 

 AMC Entertainment Holdings Inc (NYSE:AMC)

– Shares Held By Horizon Kinetics (as of September 30): 233,936

– Value of Holding (as of September 30): $12.13 Million

Horizon Kinetics increased its stake in AMC Entertainment Holdings Inc (NYSE:AMC) nearly ten-fold during the third quarter. Last year, shares of the cable network provider plunged by more than 30% and its earnings growth remained muted. According to Horizon Kinetics, that’s because the company “is in a period between blockbuster programs.” The firm is of the opinion that if AMC can create another blockbuster like ‘Mad Men’, ‘Breaking Bad’ etc., its earnings will rise significantly. Additionally, if the international cable business of the company manages to achieve the profitability level of its U.S. operations in the future, Horizon Kinetics argues that the company’s EPS could be closer to $7. Assuming that those earnings are priced at a P/E multiple of 15x, AMC’s stock could trade at $109, which is almost double the levels it currently trades at.

AMC Entertainment Holdings Inc (NYSE:AMC) is expected to report its fourth quarter results later this month and the present consensus of analysts is for EPS of $1.28 on revenue of $711.71 million. For the same quarter of the previous year, it had reported EPS of $1.23 on revenue of $678.95 million.

Disclosure: None