'Run, don't walk' from index funds, says a hedge fund manager who ran one of the best-performing mut

Publish date: 2024-08-11
2022-10-25T12:53:08Z

The classic risk-on, risk-off trends witnessed in previous market cycles don't seem to be playing out this time around. Normally, when equities fall, investors tend to flock to bonds or buy the dip, depending on their time horizons and risk capacities. 

But George Noble says the rules we have been playing by for the past few decades won't work for the economic environment we're entering now. 

He's the chief investment officer of Noble-Impact Capital and manages a newly created exchange-traded fund called the Noble Absolute Return ETF (NOPE), which he says is run like a hedge fund but wrapped in an ETF. 

He admits that equity hedge funds haven't fared well in the last decade when their performance became mediocre. This year exacerbated the negative trend as fears surrounding inflation and geopolitical tensions led investors to pull a total of $32 billion from the sector in the second quarter, according to Preqin.

Noble has had his fair share of ups and downs in the industry. In 1985, he managed the nation's best-performing mutual fund: The Fidelity Overseas Fund, which invests in foreign companies. Between 1991 to 2009, he ran two hedge funds that eventually closed. 

He appreciates that investing isn't going to get easier. Decades of low interest rates, friendly Federal Reserve policies, and low inflation have cushioned fund managers. And money that's not absorbed by the real economy goes into the financial economy, driving up the prices of some financial assets, he added.

For years, fundamentals could be thrown out the window while investors chased liquidity. In a liquidity-driven market, you often see the biggest stocks going up the most because big money needs big stocks, he said. Large-cap tech stocks like the FANG stocks, which refers to the four large American technology companies, Meta (META), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOG), reaped the benefits of this environment. 

Stocks that are in index funds were also lifted by the rising tides, as everyone crowded into them. All this chipped away at the process of price discovery, he said. 

Technology grew from 20% of the S&P 500 to now about 29%, he said. But if you look beyond sector categories, he estimates technology stocks make up over 40% of the index: For example, Amazon (AMZN) and Netflix (NFLX) are classified as consumer discretionary but they are technology-based, he noted. 

Over time, it became customary to accept that it's hard to beat the market, and passive investing overtook active investing. Long-equity hedge fund managers, indexes, and mutual funds mimicked one another.

He points to the Goldman Sachs Hedge Fund VIP Index, a collection of the top long-equity holdings within the portfolios of fundamentally driven hedge fund managers, as an example. Year-to-date, the fund is down by about 32.47% compared to the S&P 500, which is down by about 23% for the same period. 

"Hedge funds who are basically just long-only funds and drag with leverage, and they've been buying Facebook and Apple, all that kind of stuff, they're going to get destroyed," Noble said. They've been getting destroyed."

Noble parroted the words of Warren Buffett: "what the wise man does in the beginning, the fool does in the end". 

A different playbook 

As the economic tides turn and the shores dry up due to rising interest rates and quantitative tightening, he believes a different playbook is needed — and the vast majority of fund managers and index funds aren't equipped for the shift.

He believes we're looking at a two-stage bear market where the S&P 500 could hit 2,700. The first stage of the bear market is declining valuations. The second stage will be led by declining profits, which he believes we're entering now as third-quarter earnings estimates fall. 

"It's quite ordinary to have profits fall by 20% in a recession. And I think that's what we're looking at this time, could be even worse than that," Noble said. 

Right now, investors need to dig into the fundamentals instead of following the crowd. He recommends focusing on companies that are inflation beneficiaries, which means they have pricing power. You also want to be sure companies don't have a lot of debt and have good balance sheets, he added. 

For this reason, index funds, technology funds, and high-growth funds are a disaster. Investors should be in a defensive position, he says. 

"I would run, not walk as fast as possible away from any technology mutual fund or any fund investing in growth stocks. Okay? I would run, not walk as fast as possible away from any fund where the returns have benefited from the era of declining inflation and declining interest rates. So that's growth funds generally," Noble said. 

Investors could also elect to pivot towards two-year Treasury notes. Cash is a conscious alternative as well, he added. 

"People say, well gee, you know, if I put money in Treasury bills only at 4%, inflation is 6% or 8%, I'm losing money. Well, inflation is 6% or 8% now, it will come down," Noble said. "But more importantly, if the alternative is losing 25% in index funds or 30%, 35% in the Nasdaq, as has been the case this year, you're better off in cash." 

As for investors who have long-term horizons, they better be comfortable enough to withstand the volatility, he noted. There will be a lot of unwinding as we move back to normal inflation levels. 

Investors also have to understand that a recovery may take a long time. For example, if you bought the Nasdaq in March of 2000 when it was trading above 5,000, it took about 15 years to get back to even, he noted. Given where valuations are now, it's a bad time to be in the market. Over time, profit margins and valuation will revert to the mean and go back to the averages. 

"If you're buying above-average profit margins and above-average valuations, you can be reasonably confident that over any five- or 10-year period, you're going to do particularly badly in stocks," Noble said. "And that certainly was the case a year ago and it's still the case right now."

Watch:

ncG1vNJzZmivp6x7o8HSoqWeq6Oeu7S1w56pZ5ufonyqusOer2aepaOxtHnIp62eq6Seu6h5056aoWWYmrGosYyfrKecXaKur63GnqlmnJWavW6uxJqpZqWRp7imwIxrZ2tqXWZ9