1)   INTRODUCTION:

François Doyon La Rochelle:

You’re listening to Capital Topics, episode #51!

This is a monthly podcast about passive asset management and financial and tax planning ideas for long-term investor. 

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss the following points:

For our first topic, we will discuss news on bank solvency. 

And next, for our main topic, we will give you an update on the results of active management versus passive for 2022. 

 Enjoy!

 2)  IN THE NEWS: GLOBAL BANKING SOLVENCY

François Doyon La Rochelle: Our first topic today is news about Bank Solvency. James, you will address the major news story of the failure of Silicon Valley Bank, also known by the acronym SVB, in the US and the fear of contagion spreading to other US and International banks, especially after the news of the forced merger of the Credit Suisse bank with UBS in Switzerland. Credit Suisse bank was among the top 30 globally systemic important banks. Now, many of our Listeners are wondering: Is this the beginning of a major Banking crisis as we saw 15 years ago in 2008-2009 with the Global Financial Crisis?

James Parkyn:   I can understand why our Listeners and indeed most Investors would be very worried about this news. It is everywhere in the financial press. You can’t escape it. In this segment, we will try to summarize what happened and what is important for Investors to know and what is noise so they avoid making bad decisions that could negatively impact their Long-Term Investment Plan.

François Doyon La Rochelle: So, let’s start with SVB in the US. What happened and why did it fail so quickly?

James Parkyn: The story of what happened is not yet fully known. What we do know so far is that the collapse of Silicon Valley Bank was driven in part by assets it held (mostly high-quality US Treasury Bonds) that lost value when interest rates rose from near zero.  

A mismatch between its assets and liabilities caused a liquidity trap. Events moved so rapidly that it kind of resembled the storyline in the classic Christmas Movie “It’s a Wonderful Life” by Frank Capra starring Jimmy Stewart. Most Listeners know the storyline where Jimmy Stewart’s brother in the movie lost the deposit money of the Bailey Building and Loan in a deposit-envelope mix-up at the bank owned by the dreaded Mr. Potter. Very quickly news spreads in the small town that the Bailey Building and Loan were insolvent, and customers rushed to withdraw their deposits.   

François Doyon La Rochelle: Yes, this movie is one of the most loved of all time. It also perfectly illustrates a classic bank run.

James Parkyn: Economist John Cochrane in his Blog titled “How many banks are in danger?” on March 14, 2023, explains it best: “SVB failed because it funded a portfolio of long-term bonds and loans with run-prone uninsured deposits. Interest rates rose, and the market value of the assets fell below the value of the deposits. When people wanted their money back, the bank would have to sell at low prices, and there would not be enough for everyone. Depositors ran to be the first to get their money out.” And there you have it, that’s what happened to SVB, a classic run on the bank.

François Doyon La Rochelle: To better understand, we must remember the economic picture prevailing in 2022 and what precipitated this. Last year, the key issue for both the economy and the banks was inflation, which jumped above 5% after decades of around 2%. The Fed had until mid-2021 to signal it would hold rates near zero for years then shifted gears dramatically and raised them at the sharpest pace since the early 1980s. Many investors, including SVB, were caught unprepared for this new reality of higher rates.  

James Parkyn: The mechanics of Bond investing is that rising rates cause bond prices to fall, especially bonds that don’t mature for many years. It has been widely reported that SVB favored longer-term bonds for their additional yield. A fall in the value of a bank’s bond holdings could in theory reduce their capital, the cushion between assets and liabilities that absorbs losses.

François Doyon La Rochelle: How did the Regulators let this happen? 

James Parkyn: In the WSJ on March 24th, 2023, in an article entitled “How Bank Oversight Failed: The Economy Changed, Regulators Didn’t”. The article states: “As interest rates surged after years of quiescence, regulators didn’t fully anticipate the hit banks would take to the value of their bond holdings. 

The Fed as late as mid-2021 expected the era of ultralow rates to continue. Not until late 2022, when rates had already risen substantially, did regulators warn SVB that its modeling of interest-rate risk was inadequate.”

François Doyon La Rochelle: So, can we say the Regulators were not doing their job?

James Parkyn: A second factor was the failure to appreciate the danger where SVB became dependent on very large deposits. and these deposits could be withdrawn virtually any time with today’s technology. 

The WSJ article goes on to say, “Banks had come to depend more on such deposits. Regulators acknowledge they didn’t stress such a concern because the big deposits were from SVB’s and Signature’s core customers, who, it was thought, would stick around.  

François Doyon La Rochelle: The WSJ article goes on to say: “… deposits fled far faster than had ever happened before, aided both by social media-fueled fear and by technology that allowed people to move vast sums with a few taps on a smartphone.” I find it hard to believe that a large Bank with a reported USD 209 Billion in Assets would fail at such elementary risk management. Can we say it was a sort of perfect storm of events? 

James Parkyn: I don’t believe it is. We often say in our Podcast, we don’t know what we don’t know, and a Black Swan type of event is not forecastable. But this is just a case of bad risk management. 

François Doyon La Rochelle: The economist John Cochrane in his March 14th Blog seems to agree. He stated: “In my previous post, I expressed astonishment that the immense bank regulatory apparatus did not notice this huge and elementary risk. It takes putting 2+2 together: lots of uninsured deposits, and big interest rate risk exposure. But 2+2=4 is not advanced math”.

James Parkyn: The storyline gets better. Bank regulations in developed countries like Canada and the US require that they have a senior executive in a role called Chief Risk Officer or CRO. It is unbelievable but at the time of failure, SVB had no CRO.  

Journalist Ben Cohen of the WSJ wrote an Article on March 23, 2023, titled “It’s the Most Thankless Job in Banking. Silicon Valley Bank Didn’t Fill It for Months.” He wrote: “Sil­i­con Val­ley Bank’s lack of an ex­ec­u­tive in that role for eight crit­i­cal months is a re­minder that risk doesn’t have to be ex­ces­sive or ex­otic to be ex­is­ten­tial. SVB’s alarm­ing ex­po­sure to ris­ing in­ter­est rates wasn’t hard to see com­ing and should have been easy to hedge against. It re­mains flab­ber­gast­ing how a bank that served the most in­no­v­a­tive cor­ner of the econ­omy could have been doomed by a basic mismatch of assets and liabilities. But tech’s favorite bank failed because its risk management did first.”

François Doyon La Rochelle: But the SVB would’ve had other risk-reporting regulatory obligations. Ultimately, would the Board of the Bank be accountable?

James Parkyn: Yes, I agree even with no Chief Risk Officer, at the very least there should have been an acting CRO, and regulations would require regular reporting to the board on Risk management. Ben Cohen of the WSJ said it best: “Of course, the presence of a Chief Risk Officer isn’t necessary to know when the Federal Reserve hikes rates and regulatory filings suggest SVB was aware of its vulnerabilities long before the run on the bank: The board’s risk committee met nearly as many times last year (18) as it did in the previous three years combined (19).” So here again we see a big-time failure of basic governance processes.

François Doyon La Rochelle:  So, what about the Credit Suisse Bank and the merger with UBS? Is the situation like SVB? What’s the impact of Credit Suisse and UBS merging?

James Parkyn: Economic Historian Adam Tooze in his Podcast Ones and Toozes on March 17th, 2023called it a “Confidence shock that killed Credit Suisse”. Regular listeners will remember from Podcast #44 that he wrote the highly regarded book “Crashed” detailing what happened in the banking system during the global financial crisis. Unlike SVB it was not a liquidity crisis but a counterparty crisis. Other global banks and large customers were losing faith in Credit Suisse’s ongoing viability.    

This is a major issue for Switzerland and its role in the global banking system. A recent WSJ Article titled “It Wasn’t Just Credit Suisse. Switzerland Itself Needed Rescuing”. For any country, it would be a financial emergency. For Switzerland, the stakes verged on existential. Its economic model and national identity, cultivated over centuries, were built on safeguarding the world’s wealth. It wasn’t just about a bank. Switzerland itself needed rescuing.

François Doyon La Rochelle: The Credit Suisse bank crisis added the Global contagion dimension to this crisis. For the Swiss, it threatens an economic model and national identity built on safeguarding the world’s wealth.

James Parkyn: Credit Suisse, the second-largest Swiss bank, and Top 10 Global Bank, has had risk management issues for over a decade. Adam Tooze in his March 17th Podcast called it a “Confidence shock that killed Credit Suisse”. Now that Credit Suisse and UBS, the larger Swiss bank, have merged, the question is the combined bank, with over 50% of the Swiss banking market, too big to bail? 

The WSJ reported on March 22nd, 2023: “Its banking system is five times the size of its gross domestic product and larger than in most economies. UBS combined with Credit Suisse has a balance sheet twice the size of the Swiss economy.”

François Doyon La Rochelle: It is clear to me that all this turmoil will have an impact on the Central Bank’s Policymaking and their inflation-fighting maneuvers of raising interest rates. The bank collapses in the United States and the emergency rescue of Credit Suisse is likely to force central banks to weigh the trade-off between systemic risks and inflation risks.

James Parkyn: Higher rates will continue to weigh on banks’ balance sheets. They will also cause problems in other parts of the economy. Economic Historian Adam Tooze in his Podcast on March 17th, 2023 said “when Central banks increase interest rates, they are trying to impact inflation thru negative events. With such a rapid rate hiking cycle engineered by Central Banks, it was to be expected that negative economic shocks would happen. It was only a question of what would bend and what would break.”  

François Doyon La Rochelle: What is the role of Bank Regulators in this mess?

James Parkyn: Well! you know, it seems they’re always fighting the last battle with the last battle strategies and so, if you recall in our Podcast #44, we quoted Mervin King, the former governor of the Central Bank, that said: “Central Banks have to come up with new ideas and we got to forget about the mistakes of the recent past and focus on what needs to be done.” So, let's go back to Jason Zweig, who wrote in the WSJ article on March 17th “Over the past couple of decades, the Fed, the Treasury, and other authorities have stepped in time after time to stabilize the financial markets, as if failure were no longer an option. This all goes to illustrate an even bigger problem: Central authorities aren’t omniscient and omnipotent, and their efforts to wring risk out of the system may make it more dangerous, not less. Even as rules have proliferated and bailouts multiplied, the U.S. stock market has suffered four crashes of least 20% since the year 2000.”

François Doyon La Rochelle: Well now we are talking about Moral Hazard. Another quote from Jason Zweig of the WSJ: “The attempt to eradicate failure from the financial system, of course, is part of modern society’s broader push to make life itself riskless and idiot-proof, with indestructible baby strollers, child-resistant drug packaging, almost self-driving cars and shoe removal at airport security.”

James Parkyn: Another WSJ Columnist Greg Ip pointed out in his 2015 book “Foolproof,”: “…making an environment feel safer can lull many people into complacency and excessive risk-taking.” I am also reading a highly recommended book by financial historian Edward Chancellor, called “The Price of Time,” a history of interest rates. This author makes the point “The attempt to control risk by lowering interest rates reduces the cost of taking risk, and so ends up increasing the aggregate amount of risk in the system.” We have talked a lot in our podcast about normalized interest rates. We have had rates that are too low for too long and too many people have taken for granted this would simply continue.

François Doyon La Rochelle: James, what is your advice for our Listener?

James Parkyn: In preparation for this Podcast, I went back to our Podcast #44 on Central Banks that we published in September 2022. The big fear last fall was about recessions and the potential impact on financial markets. We highlighted Dimensional research that showed that Markets around the world have often rewarded investors even when economic activity has slowed. Many now feel that the specter of Bank failures will reduce lending activities by banks further increasing the likelihood of reduced economic activity. We recommend that our Listeners stay disciplined in their LT Investment plan and forget about all the noise of the moment such as Inflation, Interest rates, recession, and now we can add to the list of bank failures.

François Doyon La Rochelle: Yes indeed, our regular Listeners know, this is one of our mantras as a disciplined Investor with a Long-Term Mindset you can’t forecast the future.  

James Parkyn: In conclusion Francois, we turn to our friends at Dimensional, they produced a great article entitled “When Headlines worry you, bank on Investment Principles.”

“While every investor’s plan is a bit different, ignoring headlines and focusing on the following time-tested principles may help you to avoid making short-sighted missteps.

1. Uncertainty Is Unavoidable: uncertainty is nothing new and investing comes with risks.

2. Market Timing Is Futile.

3. “Diversification Is Your Buddy” a quote they attribute to Nobel laureate Merton Miller.

 François Doyon La Rochelle: I like the following quote from this article: “When the unexpected happens, many investors feel like they should be doing something with their portfolios. Often, headlines and pundits stoke these sentiments with predictions of more doom and gloom. For the long-term investor, however, planning for what can happen is far more powerful than trying to predict what will happen.” As usual, we will share the link with our Listeners.

3)   MAIN TOPIC: UPDATE ON ACTIVE VS. PASSIVE

François Doyon La Rochelle: For our second topic today, we will give you an update on the results of active management versus passive for 2022. I believe that by now, after all the podcasts that we have released, most of our listeners understand that we are strong believers in market efficiency and that our investment philosophy is based on the empirical evidence that using broad-based and low-cost investment passively managed products are the best way to capture market returns and increase the odds of long-term success for our clients. 

James Parkyn: Correct and it’s been more than 20 years now that we have adopted this investment approach based on the belief that active investing is a negative sum game. However, this does not mean that we don’t question ourselves and look at the latest research papers and articles to make sure our investment philosophy is supported by evidence. 

François Doyon La Rochelle: Yes, and that’s why year after year we analyze the SPIVA report, from S&P Dow Jones Indices which measures the results of the S&P Indices versus active funds, and also the Morningstar Active vs Passive Barometer report which measures the performance of active funds against their respective passive peers, to see if the results for the last year were any different than in the past. Unfortunately for active managers, this year was no different than in the past, since once again active managers were not able to beat their passive comparable.

James Parkyn: This is particularly interesting after a difficult year like 2022 when stock and bond markets unusually sold off at the same time. The old narrative from active managers is that good active management will outperform passive investments during times of market volatility, so what happened?

François Doyon La Rochelle: Well, we would certainly expect given all the market volatility in 2022, that active managers would have plenty of opportunities to beat passive strategies. 

James Parkyn: Effectively, we covered the major geopolitical and economic events in our podcast over the last year, but it is worthwhile to highlight some of them for our listeners to get a feel for the opportunities that active management could have exploited to generate better results. The year started with the war in Ukraine and the subsequent geopolitical turmoil, then followed multi decades of high inflation rates, and the subsequent swift and strong reaction from central banks to increase interest rates. Again, I am just highlighting the obvious here but getting back to our topic Francois, how well did active management do against passive last year? 

François Doyon La Rochelle: To answer your question, James, I will base myself predominantly on the Morningstar active versus passive barometer report. This report is comprehensive as it covers nearly 8,400 actively managed funds in the U.S. with approximately $15.7 trillion of assets under management. I prefer this report to the SPIVA since it measures the rate of success of active managers against the results of actual passive funds and not benchmarks.

James Parkyn: This is an important nuance. The Morningstar report “benchmarks” reflect the actual, net-of-fees performance of investable passive funds and not simply the performance of an index that is not investible without incurring fees. 

François Doyon La Rochelle: Correct James and that’s a very important nuance.

Now let’s look at the results. Again, based on the narrative that active managers will do better in times of market stress I think the results for 2022 are not very conclusive for active management. Based on the 20 different investment categories reported by Morningstar only 40.5% of active managers were able to beat their respective benchmarks in 2022. This is a weaker result than in 2021, a very good year in the markets when 51.1% of active managers were able to beat their benchmarks. 

James Parkyn: As you mentioned this is very interesting as it goes against the active management’s narrative that they will perform better in difficult years. So out of the 20 categories, what were the best ones?

François Doyon La Rochelle: Out of the 20 different categories, 6 of them had a success rate above 50%. Meaning that in each of these 6 categories, more than 50% of the managers were able to beat their benchmarks. By way of comparison, that number for 2021 was 7. That being said, the best-performing categories in 2022 were, one, the US small value category with a 61% success rate, second, the US small growth category with a 56.9% success rate and third the world large blend category with a 56% success rate. I must mention in all objectivity that the U.S. large blend category, which is probably the largest fund category by assets under management, was also amongst the best categories in 2022 with a success rate of 54.1%. This means that 54.1% of the active managers in that category beat their benchmark last year.  

James Parkyn: Now which categories fared the worst? 

François Doyon La Rochelle: The worst category out of the 20 was Global Real Estate with a success rate of only 20%, it was slightly surpassed by the corporate bond category with a success rate of 22.6% and by the diversified emerging markets category with a success rate of 23.4%. 

James Parkyn: What I find interesting in these results is that the highly interest-sensitive categories like global real estate and the corporate bond category were amongst the worst-performing categories last year.

François Doyon La Rochelle: Yes, I was also surprised by these results and by the fact that the other bond categories, the intermediate core bond category, and the high yield bond category have also had poor results with low success rates of 37.9% and 27.2% respectively. Therefore, vastly underperform their passive counterparts.

James Parkyn: Wow, I would have thought that in a year like 2022 with all the talk surrounding inflation, interest rates, and central bank decisions active management would have prevailed. Given the narrative, you would expect that active managers would be able to adjust their portfolios and reap the benefit of predicting interest rate changes.

François Doyon La Rochelle: Indeed James. I also looked at the 2022 SPIVA U.S. and Canadian reports and although they don’t analyze the performance of active versus passive in the same way as Morningstar, there were some very interesting takeaways in their report regarding the inability of active managers to outperform their respective benchmarks. The report highlights that the market conditions for equities and fixed income were uncommonly challenging in 2022, underlying however that these difficult markets gave active managers material opportunities to generate relative outperformance. Opportunities that most active managers were unable to exploit.

James Parkyn: What do they mean by that unable to exploit?

François Doyon La Rochelle: Well, if we examine the example provided in the U.S. SPIVA report, the S&P500 Growth, and the S&P500 Value indices, which are both large-cap U.S. equities indices, were respectively the worst and best-performing equity benchmarks in 2022. The report goes on to mention that more than 20 percentage points were separating their full year’s performance. Our regular listeners will remember that we highlighted in our podcast #48 that value stocks vastly outperformed growth stocks in 2022.

James Parkyn: Wow, this type of dispersion in returns should in my mind been a great opportunity for active management.

François Doyon La Rochelle: Yes, but the active managers were not able to seize the opportunity since most of them, who are benchmarked to the S&P500 Index, failed to beat it. Since large-cap growth stocks were the worst-performing asset class, a large-cap growth manager could have simply purchased stocks of another U.S. asset class to beat its benchmark. Despite this fact, close to 74% of active managers in that asset class still failed to beat their benchmark. Here is a quote from the report, “the prospect for skilled stock pickers in large-cap U.S. equities were above average and the tailwinds for even unskilled managers were unusually favorable” The report goes on to say “An examination of the particular market segments that over and underperformed shows that they should have given the advantage to active managers, in particular thanks to their ability to deviate from broad-based, market cap weighted allocations to large-cap U.S. equities.  

James Parkyn: Anything to report on the longer-term results of active versus passive?

François Doyon La Rochelle: Well, for the last 10-year period the success rate for active management in the Morningstar report is at 31.5%, meaning only 31.5% of the active managers were able to beat their passive counterparts. If you look at the 20-year results, the success rate drops even further to a low of 16.2%. In the U.S. SPIVA report what I found interesting there is that it gives the quartile breakpoints for Equity funds in the U.S. The takeaway here is that if you would have bought an S&P500 Index fund or a broader market S&P1500 Index Fund you would have effectively bought a fund that ranked in the first quartile of all active and passive funds in the over the last 5,10- and 20-year periods.     

James Parkyn: Well François that’s very compelling evidence because I wrote a blog recently and you got all this financial press “There is a recession coming…you should do this and do that with your portfolio...” and I said “Yeah, but then what? What do you do?” and often the market is going to react before the recession ends. Maybe active managers, as you mentioned earlier, the large-cap blend, 54% beat the benchmark. But then what? What about the second year? And there are taxable events and you have got to guess both events. If you’re riding a horse in active management, it’s got to continuously be at par with the market. When you show only 16.2% over 20 years beat the market and we haven’t even gotten into the tax and efficiency of active management vs. taxes. So again, based on these reports and our experience with client portfolios, we’re very confident that staying the course with our investment philosophy is doing the right thing with our customers and we believe that our listeners would agree as well.

François Doyon La Rochelle: That’s correct, no changes are planned, again it’s proof that over the long term, disciplined passive investors will earn higher returns than active investors.  

4)   CONCLUSION:

 François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge. 

 James Parkyn: You are welcome, Francois.

 François Doyon La Rochelle: That’s it for episode #51 of Capital Topics! Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com .

Also, if you like our podcast, please share it when with family and friends, and if you have not subscribed to it, please do.

Again, thank you for tuning in and please join us for our next episode to be released on May 11th.  

 See you soon!