Indexation: Capitalist Tool (Delivery agent of The Great...

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Indexation: Capitalist Tool (Delivery agent of The Great Bubble)

Some of the audience-favored slides

*Excerpts and updated presentation to the Grant’s Fall 2016 Conference. Replay to the presentation is available at: https://vimeo.com/209940152/f2154e4d3d

Valuation Sobriety Test

Semantic Mis-Investing #1: Security Diversification

Semantic Mis-Investing #2: Foreign Equity Exposure

Semantic Mis-Investing #3: High Yield (or maybe just

Low Quality)

Indexation is NOT Dependent on Individual Securities.

Really?

Semantic Mis-Investing #5: Correlation Diversification

The Pursuit and Myth of Low Beta (and accumulation

of systemic risk)

Semantic Mis-Investing #6: Indexes as Fact-Based

Investing

Are Active Managers the Anomaly, or is the Market?

Central Banks Buying Stocks, and the Destruction of

Price Discovery

The Trap: Nowhere to Go


Does an asset allocation program or robo-advisor

seeking foreign market exposure know that 7 of the

top 10 holdings of the iShares MSCI Italy Index get

an average of 68% of their revenues from outside of

Italy? That they’re essentially investing outside Italy?

The same holds true for the iShares Spain ETF. 7 of the

top 10 holdings get an average of 76% of theirrevenues from outside Spain!

Then there’s valuation. There is great demand for

the few companies of sufficient market cap, simply

as raw material for index inclusion. Might these

mega-cap global stocks out-perform truly local

Spanish stocks just due to their automatic bid? Do

global multi-nationals pose their own particular

systemic risk?

So what does manager relative performance

measure? What does country allocation measure?

Top 10 Holdings as of 8/21/2017

Source: iShares, Bloomberg, Company reports

IShares Italy ETF (EWI) % Weight

% of

Revenue

NOT in Italy

ENEL 12.5 46

INTESA SANPAOLO 10.9 24

UNICREDIT 10.5 53

ENI 10.1 62

FERRARI NV 5.0 88

ASSICURAZIONI GENERALI 4.8 62

ATLANTIA 4.7 13

FIAT CHRYSLER AUTOMOBILES NV 4.5 80

SNAM 4.1 n.m.

CNH INDUSTRIAL NV 4.0 88

Top 10 Total 71.0

IShares Spain ETF (EWP) % Weight% of

Revenue

NOT in Spain

BANCO SANTANDER SA 19.3 87

BANCO BILBAO VIZCAYA ARGENTARIA

OR10.3 74

TELEFONICA SA 8.6 75

INDUSTRIA DE DISENO TEXTIL INDITEX 7.5 82

IBERDROLA SA 4.8 50

AMADEUS IT GROUP SA 4.7 93

CAIXABANK SA 4.7 10

REPSOL SA 4.5 9

ABERTIS INFRAESTRUCTURAS SA 3.8 69

AENA SA 3.5 6

Top 10 Total 71.8%

Semantic Mis-Investing #2: Foreign Equity Exposure

How to Avoid Investing in a Foreign Market? Through Your Foreign Markets ETF



Attainment of the stated 5.44% Yield to Maturity (YTM):

• 2.4% of the portfolio has a 22.8% average YTM. The Fund will

not get a 22% YTM from these, since that is the rate on bonds

expected to default. They are temporarily paying until then.

They enhance the stated YTM by 0.55%. Without this, the YTM is

4.9%.

• If one-third of the CCC-class bonds lose only 1/3 of their value,

the YTM is reduced by 1.3% to 4.1%. Less Federal tax, the after

tax YTM is under 2.7%. And this assumes zero defaults in the

BBB-class bonds, no local taxes, no fees.

Really, a near-zero or negative real yield.*CCC: Extremely Speculative

CCC-: Default imminent, with little prospect for recovery

As of 8/21/2017

Source: iShares

iShares iBoxx $ High Yield Corporate Bond

ETF (HYG)

AUM $18.4 billion

Number of Bonds 1,032

Weighted Average Yield 5.44%

Weighted Average Maturity 4.19 yrs

Credit Quality MV%

Below BBB 98.0%

CCC* and Below 12.2%

Attainment of a Higher Return than the 5.44% YTM:

• There must be zero defaults.

• Average bond price of the entire fund is above par, at $101.2,

and the bonds must mature at 100 in an average of 4 years.

Moreover, the 79% of the bonds that trade above par have an

average price of $104.7.

Semantic Mis-Investing #3: High Yield

Not High Yield, Just Low Credit Quality



ExxonMobil is one of the most liquid stocks. Ergo, it will be found almost anywhere one can

imagine that it can be placed. It is a member of 206 ETFs.

It’s Momentum, It’s Value, Its’ a Bird, It’s a Plane…

It’s Exxon, a Stock for Every Strategy:

QUAL iShares Edge MSCI USA Quality Factor ETF

HDV iShares Core High Dividend ETF

IWD iShares Russell 1000 Value ETF

MMTM SPDR S&P 1500 Momentum Tilt ETF

PBP PowerShares S&P 500 BuyWrite ETF

TILT FlexShares Morningstar US Market Factors Tilt ETF

FTLB First Trust Low Beta Income ETF

QWLD SPDR MSCI World Strategic Factors ETF

TOK iShares MSCI Kokusai ETF

ACWI iShares MSCI ACWI ETF

SPLV Powershares S&P 500 Low Volatility Portfolio

VIXH First Trust CBOE S&P 500 VIX Tail Hedge Fund

ExxonMobil: An Exercise in Levitation

2013 2016 Change

Revenue $99.18 $54.13 -45%

EPS $7.37 $1.88 -74%

Payout Ratio 33% 159% 376%

BV/Share $40.85 $41.62 1.89%

(Net Expenditures on

Stock buybacks/share)$3.62 $0.23 -94%

Total Debt ($ bill) $22.70 $42.76 88%

12/31/12 12/31/16

Share price $86.55 $90.26 +4.3%

As of 8/21/17. Source: Morningstar.As of 12/31/2016. Source: Company reports.

Indexation is NOT Dependent on Individual Securities. Really?

The Exxon Levitation Conundrum – Or, The Problem of the Automatic Bid



Have a Hunch, Buy a Bunch!

The popular side of the ETF Divide, witnessed in the

ExxonMobil phenomenon, can be seen in almost

any large S&P 500 constituent. Money has been

structurally channeled into the most liquid securities.

It alters correlation statistics, risk statistics.

The correlation of the largest members of the S&P

500 with the index has about doubled from 20 years

ago.

Even Mexico and Japan are now more correlated

with the S&P 500 than the top S&P 500 companies

were 20 years ago!

The same holds true for Procter & Gamble, Coca

Cola and most of the rest.

Where’s the price discovery?

Correlation with S&P 500* (1/1/2008-6/30/2017)

IYW iShares US Technology 0.63

BJK Market Vectors Gaming 0.79

IYH iShares US Health Care 0.75

IYE iShares US Energy 0.71

ITB iShares US Home Construction 0.71

IYT iShares Transportation Avg 0.70

EWW iShares Mexico Capped ETF 0.67

EWJ iShares MSCI Japan ETF 0.72

Correlation with S&P 500*

Security 1995 2016 Change

Apple Inc 0.161 0.567 253%

Chevron 0.295 0.639 117%

General Electric 0.522 0.759 45%

Johnson & Johnson 0.314 0.536 71%

Microsoft 0.455 0.711 56%

Pfizer 0.191 0.495 159%

Procter & Gamble 0.370 0.513 39%

AT&T 0.425 0.431 2%

Verizon 0.436 0.471 8%

ExxonMobil 0.351 0.581 66%

Source: Bloomberg, daily returns, Horizon Kinetics Research

*Selected to show the correlation of certain non-financial S&P 500 Index constituents that have existed for more than 20 years. For illustrative purposes only. Using Bloomberg

correlation matrix.

Semantic Mis-Investing #5: Correlation Diversification

Self-defeating paradox: The failed search for diversification in ETFs



A reality: A new ETF cannot be launched without

a low Beta.

A result: These largest-in-class ETFs can

legitimately be characterized as low volatility,

since the financial sector has not been volatile

lately. And the high sector weighting enables the

ETF to attain its advertised low beta.

A rhetorical question: Is low volatility an inherent

attribute of the financial sector? Or is it perhaps

simply that the central banks of the world have

maintained an artificially low-rate environment

for a very long time?

Would anyone legitimately assert that these ETFs

will remain non-volatile if rates rise? The ETFs can’t

trade out of a low-Beta security; but they can

once the Beta rises.

Another rhetorical question: Would an active

manager of a low-risk strategy be permitted the

risk of a one-third or near-50% weighting in

financials?

Beta

What is

This

Column?

Sample Low Volatility, Low Beta, and Factor ETFs

EEMViShares MSCI Emerging Markets Min Vol

ETF-0.08 21.8%

CNY

AiShares MSCI China A ETF 0.28 27.3%

KSA iShares MSCI Saudi Arabia Capped ETF 0.30 38.6%

INDA iShares MSCI India ETF -0.01 23.6%

EIDO iShares MSCI Indonesia ETF -1.13 32.7%

FM iShares MSCI Frontier 100 ETF 0.07 44.1%

Sample Value Factor ETFs

IWD iShares Russell 1000 Value ETF 1.08 25.6%

IWN iShares Russell 2000 Value ETF 1.48 30.5%

IVE iShares S&P 500 Value ETF 1.16 27.4%

IVV Reference: iShares Core S&P 500 ETF 1.00 14.4%

As of 7/31/2017

Answer: Percentage Weight in Financials

Source: Various ETF Factsheets, Morningstar.

Source: iShares. iShares calculates Beta vs. the S&P 500

The Pursuit and Myth of Low Beta (and the accumulation of systemic risk)

The misuse & abuse of historical statistics in the ETF creation process



To translate that bewildering language into the 3-step recipe via which an egregiously

high P/E ratio is cleansed into a harmless middling sort of group average, observe the

following hypothetical portfolio consisting of a range of low, somewhat high and

egregiously high-valuations. Ponder Stock D’s treatment, and you see that the higher the

true P/E, the less and less it counts in the average.

Incidentally, a simple average of the P/E ratios of the 91 profitable companies in the

NASDAQ 100, results in a valuation of 43.6x earnings. The market-cap weighted average

(giving proportionately greater weight to the larger companies) is 41.0x. No active

manager would be permitted to manage a concentrated, high-P/E portfolio for an

institutional client. Only an index enjoys this privilege.

P/E

Ratio

Step 1:

Reciprocal of

the P/E Ratios

Step 3: Reciprocal

of the Step 2

average

Stock A 10 1/10 = 0.10

Stock B 20 1/20 = 0.05

Stock C 30 1/30 = 0.033

Stock D 300 1/300 = 0.0030_

Average P/E: 90x Sum = 0.1867

Step 2: Average of the reciprocals: 0.1867/4 =

0.0465

1/.0465 = 21.5x

Harmonic mean (From Wikipedia, the free encyclopedia)In mathematics, the harmonic mean…is one of several kinds of average…The

harmonic mean can be expressed as the reciprocal of the arithmetic mean of the

reciprocals of the given set of observations.

Semantic Mis-Investing #6: Indexes as Fact-Based Investing.

When Is A Fact Not a Fact? Or How an ETF Can Turn a 90 into 22 in Three Easy Steps



Were these active managers the

anomaly for underperforming?

And is it reasonable to believe that

they all lost their touch at the same

time?

Or was it the S&P 500 that was the

anomaly for outperforming? That

always sounds nonsensical until

after the fact.

All one can say is that if a school

consistently gave exams that 98%

of the students would fail, at least

some attention would be paid to

the teachers.

The Alpha Producers

Are Active Managers the Anomaly, or is the Market?

Fund or Holding Company

2016

Underper-

formance

in % Points (net)

2015

Underper-

formance

in % Points (net)

2014

Underper-

formance

in % Points (net)

Fairholme1 13.72% -12.88% -16.39%

Gabelli Value1 -0.36% -10.88% -12.09%

Wintergreen1 -5.29% -8.32% -15.37%

Longleaf Partners1 8.76% -20.18% -8.77%

Berkshire Hathaway2 11.44% -13.88% 13.31%

Pershing Square Hldgs3 -25.46% -21.88% 26.71%

Icahn Enterprises3 -23.59% -26.01% -21.87%

Greenlight Reinsurance3 -4.76% -21.58% -4.99%

Royce Micro-Cap1 -0.70% -8.10% -7.70%

1 Fairholme (FAIRX), Gabelli Value 25 A (GABVX), Wintergreen (WGRNX),

LongLeaf Partners (LLPFX ), Royce Micro-Cap (RMT) 2 Share price return

3 NAV per share change

Benchmark is S&P 500 Index except for Royce Micro-Cap which is relative to the Russell MicroCap Index

Source: Company Reports, Manager websites, Horizon Kinetics Research



How can a free enterprise system function if

price discovery is influenced by agencies of

government with infinite supplies of money?

An equity portfolio manager no longer

competes in the market auction process with

other buyers with limited capital. The

government, with unlimited capital, is not

motivated by ordinary considerations of fair

value. One is entitled to presume, in the

absence of evidence to the contrary, that the

aim of the Central Bank is to elevate prices. If

this is the case, what does the benchmark

mean?

Without price discovery unimpeded by

intervention, there can be no rational

allocation of capital. And without rational

allocation of capital, it is impossible to properly

evaluate the skill of the managers.

Q2 2015 Q2 2016 Q2 2017

Market value of holdings $38.6 B $61.8 B $85.0 B

Number of positions 2,581 2,581 2,643

Top 10% by weight, # of positions 258 258 264

Largest 10% as share of portfolio 74% 76% 76.5%

Average market cap of position of

largest 10% (billions)$60.4 $62.7 $70.0

Some Unexpected Holdings

Name Headquarters Name Headquarters

B Communications Ltd Ramat Gan Kornit Digital Ltd Rosh Ha'ayin

Caesarstone Ltd HaifaMellanox Tech

LtdYokneam

Cellcom Israel Ltd Netanya Neuroderm Ltd Rehovot

Check Point Software Tech Tel A.-Yafo Orbotech Ltd Yavne

Cyberark Software Ltd Petah Tikva Radware Ltd Tel A.-Yafo

Elbit Sys Ltd Haifa Taro Pharma Inds Haifa

Gazit Globe Ltd Tel A.-Yafo Tower Semicond. Migdal Ha'emek

Israel Chemicals Ltd Tel A.-Yafo Wix Com Ltd Tel A.-Yafo

Ituran Location & Control Azour

Q: Which Index Fund Would Be the 3rd Largest ETF in the U.S.?*

Source: sec.gov 13F Filings, Bloomberg

* From the Swiss National Bank: “The SNB does not engage in equity selection; it only invests passively. It first decides in which

markets it wants to invest, and then replicates appropriate broad equity indices. If the equity portfolio were managed actively,

this could send undesirable signals to the market, and might also lead to the politicization of investment decisions.”

Central Banks, Equities and, Of Course, Indexation

Still believe in price discovery?



CRSP U.S. Total Market Index, as of 3/31/17, comprising

over 3,500 companies and $26.9 trillion.

Small-capitalization stocks (less than $2 billion), a

traditional alternative to over-valued large-cap

stocks, are no longer a practical option.

At only 4.6% of the total market, they cannot

absorb a sufficient portion of the equity pool;

they cannot be a functional alternative.

Real estate, perhaps the largest industry in the

U.S., should be an alternative. Yet, publicly

traded real estate is only 4.1% of the stock

market, so is not a practical option either.

Moreover, publicly traded real estate likewise

trades near all-time high valuations.

Accordingly, investing must now take place

outside of the indexation sphere of focus. While

that can’t take place for the majority of investors,

it can for a small minority.

80%

4.6% 4.1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Large Cap Small Cap REIT

% of Overall Market

The Trap: Nowhere to Go

The Unavailability of Alternative Asset Classes/Sectors



Disclosures

Past performance is not an indication of future results and the value of the investments and the income derived from them may increase or decrease. It should not be assumed that any of the holdings

referenced herein have been or will prove to be profitable or that future investment decisions will be profitable or will equal or exceed the past investment performance of the holdings listed.

Indices are presented merely to show general trends in the markets for the period referenced and are not intended to imply that a strategy is benchmarked to the indices either in composition or level of risk.

Indices are unmanaged and the figures shown herein do not reflect any investment management fee or transaction costs. Investors cannot directly invest in an index. References to market or composite

indices, benchmarks or other measures of relative market performance (a “Benchmark”) over a specific period are provided for your information only.

The S&P 500 Index (“SPX”) is a broad based index widely considered as a proxy for overall market performance. It is the property of Standard & Poor’s ®.

All ETFs mentioned have fees and expenses. You should read their prospectus before investing. All material presented is compiled from sources believed to be reliable, but no guarantee is given as to its

accuracy.

iShares® and Blackrock® are registered trademarks of BlackRock, Inc.

PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (Invesco PowerShares) and Invesco Distributors,

Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.

Except as noted, the portfolio characteristics shown for separate accounts relate to the composite as of the date noted above. Not every client's account will have these exact characteristics. The actual

characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) market prices of individual securities at the time of

investment and (iii) individual client circumstances. Horizon Kinetics LLC reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The

strategies listed herein may invest in both equity and fixed income securities, among others, without regard to market capitalizations or issue size. Horizon Kinetics LLC does not necessarily fully invest portfolios

immediately after an account is funded. There can be no assurance we will ever fully invest an account. There is no assurance that any securities discussed herein will remain in an account. The securities

discussed might not represent an entire account and in the aggregate may represent only a small percentage of an account's holdings.

This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed indications concerning the manner in

which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer or solicitation to any person in any

jurisdiction in which such action is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

Horizon Kinetics LLC is not a registered investment adviser, but serves as parent company to, among others, Horizon Asset Management LLC (“Horizon”) and Kinetics Asset Management LLC (“Kinetics”), both

of which are registered investment advisers. Horizon Kinetics LLC, its subsidiaries, employees, or products managed by Horizon and Kinetics may have positions in the securities referenced in this presentation.

Horizon is the investment manager to the strategies referenced herein. All material presented is compiled from sources believed to be reliable, but no guarantee is given as to its accuracy. The information

presented is subject to further clarification during presentations.

Historical Statistic Definitions

Excess Return is the measurement of a portfolio’s return minus the return of an index.

Standard Deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to a specific market index.

Turnover is the lower of total buys or total sells divided by average market value of the account. Turnover ratio source: Fiserv Security APL.

Equity yield curve is when discounted securities and their market prices realize their underlying economic values. The further out the potential investment reward, the steeper the equity yield curve will be.

Neither Horizon Kinetics LLC nor its subsidiaries provide tax or legal advice to their clients and all investors are strongly urged to consult their tax and legal advisors regarding any potential strategy or

investment. Opinions expressed are Horizon Kinetics’ present opinions only. No part of this material may be: a) copied, photocopied, or duplicated in any form, by any means; or b) redistributed without

Horizon Kinetics’ prior written consent.

All rights reserved © Horizon Kinetics 2017

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