Unhedged Commentary: The Rise of Fundamental Insensitivity

June 14, 2016  

      Oliver Marti, Columbus Circle Investors

By Oliver Marti

Over my 25 years of equity research and investing, including the past 15 years managing a health care long-short strategy, I’ve witnessed many changes in what drives stock prices — including the influence of monetary policy decisions, the increased speed and amount of information (or misinformation) distribution and the significant decline in order size. But I am now observing a change that is more significant than any I’ve previously seen. The massive growth in exchange-traded funds is changing how stocks trade and are priced, bringing new challenges as well as opportunities for investors.

Numerous statistics suggest the number of U.S.-listed ETFs has increased from 100 in 2000 to more than 1,500 today, with assets under management growing from less than $100 billion to roughly $2 trillion over the same period. The Investment Company Institute, a mutual fund trade association, reports that since 2008, $410 billion has flowed out of mutual funds, while at the same time, $1 trillion has gone into ETFs. Based on the growth in ETFs, it is estimated that on average the percentage of U.S. trading volume coming from ETFs has gone from virtually nothing in 2000 to approximately 25 percent in 2016.

This growth is having a profound effect on how stocks are priced and has implications beyond the usual debate about passive versus active management. ETF growth is driving a de-emphasis on investing in individual stocks based on their merits and a move toward sector bets and factor model investing, grouping stocks of the same ilk in one basket. Many have heard the term smart beta, but the term I think best fits this fast-growing trend is fundamental insensitivity.

Investing in ETFs can allow investors, especially individual investors, to build diverse portfolios, get exposure to specific sectors, avoid company-specific risk, hedge and pay lower fees — all positive attributes. However, as ETF-based strategies have exploded in size, an unintended consequence has been an increase in periods of erratic price movements in stocks sharing similar characteristics. (I also believe the growth in quantitative funds may be having an equally large impact, but data in this area is harder to come by.)

Prices are increasingly affected by demand and supply for an asset class, style or sector, instead of being driven by individual business fundamentals. Investor demand to move in or out of certain sectors or factors can drive a particular asset, stock or sector meaningfully away from its intrinsic value, often extremely rapidly. This effect is elevated during periods of rising uncertainty and higher volatility, and the impact tends to be greatest on lower-liquidity and smaller market-cap names.

For fundamental investors, it is now more difficult to determine what is in fact discounted into a company’s valuation. How much of a stock’s move is fundamentally driven? How much is positioning? With the increase in ETFs, along with quant funds, it seems more and more that a significant portion of a company’s price movement is driven by investors simply getting long or short exposure to a trend, factor or sector that is in or out of favor. Stocks of the same ilk get grouped together with little differentiation between fundamentally stronger and weaker companies.

My team and I have seen the general phenomenon of ETF growth play out specifically in the health care sector. A Bank of America Merrill Lynch analysis utilizing data from research firm EPFR Global shows assets in health care/biotechnology ETFs have greatly surpassed assets in health care/biotech mutual funds since 2013. In fact, the analysis suggests that today, of the total U.S. assets in health care/biotech, only a third is actively managed, with two thirds passively managed. What that means is that correlations rise, and over shorter periods of time, nonfundamental factors can drive stock performance, both long and short.

We believe these changing dynamics have had a significant impact on the stock prices of many companies in the health care industry since July 2015. Health care witnessed a sudden rotation out of favor, with biotechnology companies hit the hardest as evidenced by a first-quarter 2016 decline for the Nasdaq Biotechnology Index that was the worst on record.

While it is fair to conclude that there is increased uncertainty around health care policy and drug pricing, the uniform and rapid decline in stock prices across biotech seems to be a symptom of the changing ETF marketplace. Data provided by Credit Suisse’s Quant & Equity Trading Strategy team regarding trading in the SPDR S&P Biotech ETF (XBI) suggests that this single ETF at times contributes an estimated 30 percent or more of the average daily volume in many of the stocks it holds. Other ETFs holding those same stocks drive that figure higher, demonstrating how ETF trading can have an outsize impact on volume and therefore on stock price movements.

An uncoupling of stocks from underlying value has and will at times make fundamental long-short investing more difficult during short-term periods, since correct assessments of stronger and weaker companies are less likely to be rewarded in near-term price movements. However, we still believe that companies ultimately will be priced on intrinsic value, and therefore the erratic pricing we are seeing is creating more situations where companies are materially under- or overvalued.

This increase in the number of significantly mispriced stocks should mean higher long-term returns for managers and investors who can identify these situations and have the patience to stay the course. In our sector, health care, we believe the market has overreacted to potential changes in health care policy, which is creating excellent investment opportunities.

Oliver Marti is Senior Managing Director at Columbus Circle Investors and manages the CCI Healthcare equity long-short team.

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