FT BIG READ - STOCK MARKETS - The return of the stock picker

25 September 2017

 For the past decade, cheap index funds have outperformed the vast majority of equity managers. But as central banks withdraw money from the financial system, active investors believe it is their moment.

Next January the Omaha branch of Girls Inc, a venerable charity dedicated to helping young women across the US, will receive a $1m cheque in the mail from a New York hedge fund, after a bet entered into a decade ago went horribly awry.

The wager was struck between Warren Buffett, the billionaire “Sage of Omaha”, and Ted Seides of Protégé Partners, on whether a Vanguard fund that simply tracked the S&P 500 would beat a basket of hedge funds. The result? The cheap and cheerful index-tracker thrashed the hedge funds, leading Mr Seides to concede defeat early.

“For all intents and purposes, the bet is over. I lost,” he wrote in a column this year. In his latest letter to investors in February, Mr Buffett took a victory lap, writing there was “no doubt that Girls Inc of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organisation eagerly opening the mail next January”.

The “Buffett Bet” underscores how the past decade has proved tough for many professional money managers. It has been a particularly miserable period for the once-venerated tribe of stock pickers, who parse through reams of corporate reports and economic data to unearth companies that will outperform the equity market. Less than 15 per cent of US stock fund managers succeeded in beating their benchmarks in the past 15 years, according to S&P Dow Jones Indices.

The woeful performance has accelerated a tectonic shift towards cheap, passive, index-tracking funds and triggered a bout of near-existential angst in the traditional, “active” investment industry. Indeed, active US equity funds have not enjoyed a calendar year of net inflows since 2005, and barring a miracle 2017 will not snap the losing streak.

But the skies are brightening. In the year to June 2017 over half of all US equity mutual funds outperformed their benchmarks, according to the latest flagship scorecard from SPDJI released last week. Equity hedge funds are also enjoying a welcome hot streak. On average they have gained 8.6 per cent this year, according to HFR, the research group, making this the strongest run in four years.

“While passive strategies clearly have had the upper hand from 2009-2016, historically there has been a clear cyclicality in the leadership between the two,” Andrew Folsom, a senior investment analyst at Wells Fargo wrote in a recent report. “We could be in the early stages of an ‘active versus passive’ regime change.”

The reason for the abrupt change in fortunes is a quiet but radical shift in the stock market. For much of the post-crisis years, it was dominated by a phenomenon dubbed “ ro-ro”, or risk-on, risk-off - where share prices tended to move in unison. Rather than fundamental analysis of individual companies, share prices were dictated by both a series of economic shocks emanating from the US, Europe or China, and by the central bankers who responded by spraying the financial system with trillions of dollars.

But connections between individual shares and broader stock markets have weakened sharply this year, a swing so powerful that analysts at Bernstein dubbed it “ The Great Correlation Collapse”. For stock pickers who rely on one-off movements to showcase their skills, it has been a welcome development.

“We’ve been in a period where correlations were tight, but that’s breaking up. There are more opportunities to differentiate yourself,” says Tim Armour, chief executive of Capital Group, the $1.5tn asset manager.

Yet important questions remain. Is this bout of outperformance a flash in the pan, or a secular shift to the more active manager-friendly environment of the past? And what does the abrupt correlations slide say about where we are in the market cycle?

Passive tidal wave

The passive investment industry has been gaining adherents for decades. But it took the financial crisis and the subsequent spell of dismal performance by active managers to create a tidal wave of money into exchange traded funds in particular.

In August, the global ETF industry crossed the $4.4tn mark, having grown by over a fifth this year, according to ETFGI, a data provider. To put that in context, nearly $1.8bn has flowed into ETFs each day this year, almost $74m every hour, $1.2m every minute, or over $20,000 for every second of every day of the eight first months of 2017 - including weekends.

The flows were particularly strong last year, when many stock pickers failed miserably. Indeed, just buying the 10 companies least favoured by mutual funds at the start of 2016 - as measured by their holdings - would have made 13.4 per cent last year, according to Savita Subramanian at Bank of America. The 10 most popular picks only rose 5.9 per cent.

That was at least the third year in a row where it would have paid off to do the opposite of what fund managers did. But this year’s correlation collapse and concurrent renaissance for stock pickers has nurtured hopes for a comeback after the dark days of 2010-16.

The shift is profound. The correlation between individual stocks within the S&P 500 and the index itself has collapsed to the lowest since 2001, according to Charles Schwab. (The higher the correlation, the more share prices are moving together in unison.)

Morgan Stanley analysts estimate the correlation between the US equity benchmark’s constituents is about 18 per cent, one of the lowest levels since 2004 and down from roughly 60 per cent last year.

“It feels like the market on several fronts is being set up for a sustainably good environment for active investing,” says Brian Hogan, head of Fidelity’s equity division. “It really feels better.”

Global growth returns

Explanations for the “great correlation collapse” abound, but this year’s firm, broad-based global economy is probably the main cause. When growth was relatively weak between 2010 and 2016, every data point and central banker utterance dominated investor sentiment, to the detriment of specific corporate or industry issues, says Andrew Sheets, a strategist at Morgan Stanley.

There are still some blotches. While muted correlations make the market more fertile for stock pickers, Andrew Acheson, a fund manager at Amundi Pioneer Asset Management, points out that the “dispersion” - the extent of the difference between the good and bad performers - is still subdued. “Making the right decisions aren’t rewarded as much as we’d like,” he says. “Overall, the environment has improved, but not as much as we would like.”

Nonetheless, active managers have enjoyed a bout of resurgent performance. US equity funds have on average returned 18.7 per cent in the 12 months to the end of June, narrowly surpassing the broad S&P 1,500 index’s total returns of 18.1 per cent, according to SPDJ’s flagship Spiva report on active managers.

That translates to 52.5 per cent of all funds beating their benchmarks during that period. That may sound underwhelming, but it comes after a 10-year period where less than 15 per cent managed to do so.

“I have felt like we are a good house in a bad neighbourhood, but the neighbourhood is getting better,” Mr Hogan says. “This is a good market for active managers.”

Lower fees also help. Competition from cheap passive funds has forced many asset managers to cut their prices, making it easier for funds to beat their benchmarks after fees. The average expense ratios of US equity funds have fallen from about 99 cents for every $100 invested in 2000 to 63 cents in 2016, according to the Investment Company Institute.

The brutal post-crisis environment may also have flattered the average mutual fund’s performance, with many weaker portfolio managers falling by the wayside. Indeed, SPDJI estimates that in the past 15 years about half of all US equity and bond funds have been closed down or merged. And with passive investors a bigger part of the market, there are more anomalies, distortions and inefficiencies that skilled stock pickers can take advantage of.

Beating the market

This may be a false hope, however. Michael Mauboussin, head of research at BlueMountain Capital, argues that the cull of weaker fund managers actually makes the market harder to beat - he compares it to a poker game where the departure of poorer players complicates life for the remaining card sharps.

“We don’t know if that’s right,” he concedes, “but we do know that it is getting tougher, not easier.”

It certainly makes sense to Bob Landry, chief investment officer for USAA. He points out that most of the money flowing into ETFs has been from the retail investors who used to be the “low-hanging fruit” that the professional money managers could pick off. “With fewer retail investors you have more fund managers going mano-a-mano,” he says.

Low correlations are also a classic sign of a bull run on its last legs. The US stock market’s post-crisis rally became this month the second-strongest in history, and Mr Sheets observes that the current environment is reminiscent of 2005-07.

“Maybe we have two years left, or maybe we have six months. I think we’re talking about less than two years,” he says.

Some fund managers welcome this, arguing that more volatility - or even a bear market - is just what stockpickers need to prove their worth against simple index-trackers.

However, Bank of America’s strategists have found no evidence that higher volatility helps mutual funds perform better. And the data to support the argument that active managers outperform in bear markets is also patchy, argues Matt Hougan of InsideETFs.

“Data are a tough taskmaster,” he says. “That active managers do better than passive ones in bear markets makes intuitive sense, but the data doesn’t show it.”

Even with these caveats, many money managers hope that 2017 is just the start of a lasting swing of the pendulum back in favour of active equity investing. The signs, so far, are at least encouraging.

There have been both secular and cyclical forces propelling money into passive funds - a long-term shift driven by rising awareness of the advantages, accentuated by the patchy performance of many stock pickers. But now, at least, the result from stock pickers may be improving, says Matthew Peron, head of global equities at Northern Trust Asset Management.

“I’m cautiously optimistic,” he says. “The structural trend will continue to send money flowing into passive products, but it’s been so unbalanced, and maybe we will get some more balance now.”

Nonetheless, the recent improvement is fragile. If the global economy falters - as is inevitable at some point - then many investors will probably revert to a monomaniacal focus on the latest data releases, to the detriment of the minutiae of corporate fundamentals and frustration of stock pickers.

Yet the momentum in favour of passive investing is so powerful that the outflows will probably continue for the foreseeable future, warns Liz Ann Sonders, chief investment strategist at Charles Schwab. “Stock pickers used to be rock stars. But those days are gone,” she says.

Rate hikes: Rising interest rates help active fund managers

While the impact is clear, there are myriad explanations for the “great correlation collapse” that has helped buoy active managers this year. Some think a shift in the interest rate regime is the core cause - and will present a tailwind in the coming decade.

Wells Fargo reckons the seeds were sown as far back as December 2015, when the Federal Reserve finally begun to raise interest rates. While most active equity fund managers still suffered a torrid time in 2016, the tightening path of the US central bank allowed investors to begin “to consider the potential winners and losers from the change”, the bank wrote in a recent report.

“As a result, company fundamentals seem to have returned to the forefront of investors’ minds, and the search for ‘yield at nearly any price’ has abated as other asset classes are becoming more attractive than yield-focused equity on a relative basis,” the report argued.

Given that bond yields remain low and the hunt for returns is as ferocious as ever, this might seem like a poor explanation. But research done by Fidelity indicates that rising rates do correlate with better performance.

Since 1980, US “large-cap” equity funds that track the S&P 500 have on average underperformed by 40 basis points in months when the 10-year US Treasury yield has fallen, but outperformed by 27 basis points when it has risen. Given that bond yields have generally been falling for the past three decades, this might help explain why active managers have done so poorly. But with central banks across the globe tiptoeing towards tighter monetary policy, rising bond yields could provide further performance uplift in the coming years. At least that is what active managers hope.

Speed read

Bad bets - Active equity managers have performed worse than low-cost index funds over the past decade

Cash flows - There has been a dramatic shift of money into passive investment funds since the financial crisis

Weaker correlations - Share prices have moved less in unison this year, giving hope to active investors




word count:2192

Copyright The Financial Times Limited 2017


(c) 2017 The Financial Times Limited