Index Funds Have to Buy Certain Industries Like Airlines—We Don’t

I love the empirical study of economics and business. While I ultimately chose to become a stock analyst and then portfolio manager, my training in graduate school largely focused on economics; I enjoyed looking at the “big picture”.

Far from being a “dismal science,” I found economics fascinating. At that time, the teaching of economics was in transformation, and mathematicians were taking over from the old-school social scientists.

Mathematicians applied their methods of data analysis and testing to see if the data statistically proved or refuted long-held theories in the economic field. As a student, this meant I was required to understand statistical method, the pitfalls of analyzing data, and how to properly test theories.

I did not go into economics as a profession but have relied on that invaluable fundamental training throughout my career.

In my opinion, a vast majority of claims about what to expect in the stock market (often stated as statistical fact) are simply opinions formed from looking in a rear-view mirror.

For example, the value of indexed investment vehicles was first proposed as the Efficient Market Theory. When indexes started a run of outperforming most active managers, Wall Street (never to miss a marketing opportunity) began rolling out a host of index investment products. Money has flooded into index investing ever since.

But I always ask the simple questions…

If Microsoft (as an example) is 10% of an index, why is that the amount absolutely everyone should own? Why should I have 12% of my investments in oil and gas, when I don’t really want to own oil and gas right now?

Well that’s what happens when you own an index fund.

I believe what you own and the amount you should own should be based on your own analysis and outlook for each stock you buy. If you don’t want to do the work, you need to hire someone whose opinion you value and whose work is sound.

The outperformance of index funds could end one day, and I think it will.

Why? I don’t know.

I do know that index funds own more of a company simply because they are larger, and they build their commitments to individual companies based solely on the company’s size. I don’t believe that the company’s size is the most important variable in predicting its future performance, therefore I don’t believe index funds are the best place for your money.

Looking in the rear-view mirror is equally risky when applied to an industry.

Historically, the airline industry has been a terrible place to invest. Throughout, it’s been rife with underperforming companies, bankruptcies, and volatile earnings.

Still, in my career I’ve seen Wall Street repeatedly rally around this beleaguered industry and proclaim to investors that “this time it’s different.” For those of you old enough to remember, I view it like Lucy holding the football for Charlie Brown to kick.

Although air travel is a growing industry, it’s still a very capital-intensive industry, and highly dependent on general economic activity. If the economy takes a downward turn, air travel suffers and airline’s earnings collapse. No matter what an individual airline does to improve their outlook, they exist in a cyclical industry.

Over the years, the airline industry’s earnings have been highly dependent on the price of fuel. Not surprising, if crude oil prices rose, airline stocks suffered. If crude fell (for a reason other than recession), the stocks would rally.

So, can we look at the complete collapse of oil prices over the last month as a sign of hope for airlines earnings? I don’t think so. Historic correlations between oil prices and airline earnings can be tossed out the window.

The most important variable today for airlines is something we cannot know at this moment: the rate at which consumers begin to believe that airline travel is safe again.

However, even if a cure for COVID-19 is found next week and consumers quickly regain confidence, we also have to pay attention to what businesses are learning right now.

Most every business just went through a crash course in remote commerce. The crash course was taken out of necessity, but I think they learned more than expected.

I believe that businesses are learning they can engage with customers in meaningful ways without flying out for meetings. It’s certainly cheaper, and if it proves equally effective it will change how the airline industry recovers.

Business travel is the airline’s bread and butter; their most profitable business. It may be the new normal to greatly reduce demand for air travel by businesses—the rear-view mirror won’t see that.

There are many factors in making a proper investment decision. At Nicollet Investment Management, we’re working hard to determine who the winners and losers will be going forward.

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