And what is good, Phaedrus,
And what is not good --
Need we ask anyone to tell us these things?
Zen and the Art of Motorcycle
Maintenance: An Inquiry into Values (1974)
September 5, 2024 |Through the end of August 2024, the WGA Bank Top 25 Index (WBXXVW) was up over 50% vs the Invesco KBW Bank ETF (KBWB) down small since 2022. Why this divergence? One big reason is that a lot of equity managers moved out of large cap financials in Q1 2023 and a year later in 2024. The exodus continued as worries about a recession grow amongst the thundering herd. But as we noted in our last comment: What recession?
The fact that equity market valuations have been inflated by the Fed’s actions feeds the fear and loathing among investors. Indeed, it was the fact of secular inflation going back decades to Fed Chairman Alan Greenspan that made passive strategies appear to be efficient. We hope this is not a completely new revelation to our readers. As we note in the upcoming re-release of "Inflated: Money, Debt & the American Dream" by Wiley in 2025, rising inflation is the constant over the past 50 years of US history. Buy stocks.
Ponder the fact that residential home prices have risen 40% during the four years of the Biden/Harris Administration. Was this just the result of supply chokepoints in home construction? How much will home prices rise in 2025 if the Fed cuts interest rates? Can the Fed really, really continue to talk about 2% price stability as a credible monetary policy goal if home prices rise 10-20% next year? Think of how the volatility caused by the Fed's actions has impacted asset valuations from Miami condos to large publicly traded financials.
Another factor we see operating in the divergence between the WGA Bank Top 25 and the KBWB is a matter of selection and the role of these choices on passive strategies. The “representative” basket in the KBWB was picked by a group of investment bankers based primarily on size. The index holdings do not change. KBWB represents large cap banks and, as a result, consistently ignores some of the better performers in the industry. Indeed a third of the banks in the KBWB basket perform well-below the average for Peer Group 1, as shown below.
Source: FFIEC
WGA’s WBXXVW index, on the other hand, essentially self-selects as a result of a five factor census we conduct each quarter. WGA ranks the entire population every quarter, then employs a unique pure constituent weighting system in constructing the Indices developed with our partners at Thematic. Notice in the table below that only three banks, JPMorgan (JPM), First Citizens BancShares, Inc. (FCNCA) and International Bancshares Corporation (IBOC), were in the WGA Bank Top 10 Index for the past three quarters.
WGA Bank Top 10 Index
Source: WGA LLC
Our qualitative approach to constructing the WGA Indices ensures that the highest scoring banks have the greatest impact on the Indices regardless of size. Because of WGA's unique methodology, the Indices are generally uncorrelated to existing bank indices and passive strategies. Index constituents are updated each quarter and are available to subscribers to the IRA Annual Service. We also make the entire 108 bank test group results available to Annual Service subscribers upon request.
So what does this divergence between WBXXVW and KBWB suggest? First and foremost, when the Street does not like banks, the large cap names captured in the “representative” basket of KBWB get hammered. The passive strategy is, well, passive and does not respond to changes in the macroeconomic views of equity managers. When managers want to avoid large caps of whatever market sector, they avoid most passive bank strategies.
More than most sectors of the economy, banks are a play on credit. If you think a recession is coming, then banks are likely to suffer. This applies especially to big banks with so-so financial metrics and highly mobile institutional shareholders. Yet the impressive performance of the WGA Bank Top 25 Index suggests that an active strategy focused on the top performers can significantly outperform passive strategies. Smaller banks with strong historical performance also tend to have smaller and, at times, more loyal shareholders.
Another wrinkle in the flan comes from the nature of the active management. If we are talking about people picking stocks, then all of the normal caveats about cognitive bias and illusions come into play. Think about the managers who love Ally Financial (ALLY). But what about an active census designed with numerical rules to let the bank stocks self-select? We reached Nom de Plumber at a secret risk management cluster buried deep inside a moneycenter bank and asked for his guidance on the issue of active vs passive. He opined:
“Actively managed equity funds, even if diversified, can consistently underperform passive, low-cost index funds, ironically because of single-name risk. Even without seemingly high portfolio concentration, that performance lag can accumulate sharply over time, especially if key market themes like AI manifest abruptly. How? By actively under-weighting the RIGHT stock, or over-weighting the WRONG stock, even if a seemingly small degree or for a brief period. John Bogle was right. Thank you.”
We always take note of the sage wisdom of Nom de Plumber, especially when it comes to human intervention in the investment process. When large cap banks come back into vogue and the great herd accepts that we are not in a recession yet, then perhaps KBWB will outperform the better banks? We are only in the third quarter of publishing the WGA Bank Top Indices, but so far picking quality banks seems to matter more than following the passive ETF herd.
In a future issue of The Institutional Risk Analyst, we will be
publishing the IRA Bank Book for Q3 2024.
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