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Fund Analysis: Assigning the Wrong Motivations for Traditional Active Management

Benjamin M. Lavine, CFA, CAIA

As a financial writer tasked with analyzing market- and industry-related trends, I can sympathize with how challenging it can be to maintain some semblance of methodological neutrality and objectivity, particularly in areas that lie just outside your sphere of expertise.  On several occasions, we’ve published several political pieces (here and here) but mostly within the context of how investors should not overreact to the politics of the moment. 

So, it is with some reluctance that we publish a piece criticizing this article, “Active Funds Could’ve Rocked Gun Stocks.  Instead, They Passed,” from Bloomberg Intelligence writer Eric Balchunas, a frequent publisher of Exchange-Traded Funds (ETFs) topics and astute industry observer.  Based on the tenor and tone of the article, it is fairly obvious where Mr. Balchunas stands on the politics of gun ownership, but, let’s be clear, it is not Balchunas’ political bias that this article takes issue with, nor is this article an endorsement of either side of the gun ownership issue. 

This article will not address the recent call to ‘boycott’ major index providers because their funds happen to hold gun manufacturer stocks at their free market capitalization weights (except, that is an absurd boycott given that it fundamentally fails to understand the nature of indexing).  Until gun manufacturing and gun ownership are outlawed in this country, they are still considered legal enterprises to operate businesses in (something that can’t necessarily be said of business engaged in the growing and distributing of marijuana – which is quickly becoming the investment de jour). 

What this article takes issue with is the reasoning behind Mr. Balchunas’ article, namely that ‘good publicity’ should be of primary considerations and motivations, rather than investment fundamentals, that drive the decision-making of traditional active managers on whether to hold gun manufacturing stocks or not.  Balchunas maintains that traditional active managers:

 “…would have looked like heroes (at least to the news media and half the country) and more importantly showcased the leverage they have over companies, helping them at a time when customers are leaving their funds for passive index products.”

In addition, Balchunas makes somewhat of an absurd implication that the profit dynamics of traditional active management are what is causing active funds to be “so quiet and so unimaginative when it comes to fighting passive in the growing battle for the hearts and wallets of investors.”  It is as if traditional active managers can stem the tide of money flowing to passive if they would only take an active stance on hot-button political issues, rather than lower their fees to compete with or outperform passive. 

We Are Not Active Managers, But Active Managers, Presumably, Focus on the Fundamentals

Helping to buttress his argument for traditional active managers to sell out of their gun manufacturing holdings, Mr. Balchunas makes the point that many of these stocks have underperformed the Russell 2000 Index by 60-70% over the past five years.  So, holding these stocks would have been a negative contributor to relative performance, and traditional active managers are compensated to outperform their benchmarks. 

However, the gun manufacturer underperformance needs to be seen in deeper context, namely that most of this underperformance has occurred in the last year (and much of it prior to the tragic Parkland School shooting.  Prior to the November 2016 election, gun manufacturers had handily outperformed both the Russell 2000 Index and the Russell 2000 Consumer Discretionary Sector (Figure 1: using American Outdoor Brands (ticker AOBC) as a proxy – this is not an endorsement of taking an investment position in the stock or gun manufacturers as a whole).   As an aside, investors should be cautious when investing in political themed-baskets based on certain electoral outcomes.

Figure 1: Most of the Poor Relative Performance of Gun Manufacturing Has Occurred Over the Last Year (Price Performance Ending 4/18/2018)

Source: Bloomberg

If we were to go back to the period prior to the election, managers holding gun stocks would have been the “heroes” rather than the goats of today.  This is just a reminder that performance is all about which end points you reference, and Mr. Balchunas happens to choose an endpoint that seemingly bolsters his argument.

But why the sudden drop off in relative performance for gun manufacturers? Did the Parkland school shooting signify a change in political sentiment that would lead to conditions (i.e. a drop-off in demand, greater regulation) not conducive to running gun-related businesses?  Perhaps.  We don’t profess to be fundamental investors nor can we speak to the reasoning that drove investors to sell gun stocks, but we suspect that much of the reasoning was due to ‘fundamentals’ rather than the politics of the moment. 

Now, we are not oblivious to the fact that traditional ‘fundamental analysis of a stock’s potential for investment should only comprise company-specific information but should also incorporate macro and political considerations.  But, if we take a closer look at AOBC, we can see that the stock peaked right around the time key fundamental performance metrics started to turn south.  In Figure 2, we display the Return on Invested Capital, Operating Margins, and Cashflow from Operations / Total Debt Ratio of AOBC.  All three noticeably dipped from their recent 2016 peak levels. 

Figure 2: Did Investors Flee AOBC Because of the Deteriorating Operating Fundamentals?

Source: Bloomberg

So, one could argue that the deteriorating stock price of AOBC was due to poor management, whether due to inefficient operations, capital allocation, ineffective marketing, etc, rather than the politics of the moment.  In other words, AOBC management figuratively shot themselves in the foot, and investors have voted with their feet. 

What should then motivate an active manager in their decision to hold AOBC or other gun manufacturers is not publicity but whether there is a strong fundamental argument for investing in these stocks in light of the deteriorating fundamentals.  For instance, should the active manager take a more activist bent and challenge company management in how they manage the company and allocate capital?  But it is not the role of traditional active management to ‘virtue signal’ to the market and their investors unless that expectation is clearly spelled out in the prospectus. 

Despite the strong performance of the markets post the November election, the political atmosphere is much more charged today, particularly in the age of social media.  But, we would argue that traditional active management is better sticking with fundamental analysis, rather than worrying about public relations – the former is what should motivate fund managers since investors are not paying them for public relations.  Unless it’s clearly spelled out in the prospectus mandate, the reason to dump gun manufacturing stocks should be due to how poorly they are managed rather than whether makes good PR sense for the active manager.  This should serve as a time-tested principle that goes beyond the issue of gun manufacturing and distribution.

As of the writing of this article, 3D holds or may hold AOBC or other gun manufacturers through the ETFs held in the firm’s model portfolios. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of April 18, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing or visiting 3D’s website

By: Benjamin Lavine