Friday, September 16, 2016

A Crisis in Active Management?

Charles Stein of Bloomberg reports, Failing to Measure Up Is $422 Billion Stock Pickers' Crisis:
You don’t have to look far to explain why investors are yanking money from mutual funds run by stock pickers.

Only 9.5 percent of actively managed large-cap domestic equity funds beat the S&P 500 Index in the five years ended Aug. 31. That’s the worst five-year performance since 1999, according to data from Morningstar Inc.

Investors are paying attention. About 3,000 actively run funds in that category saw redemptions of $422 billion over five years, while passive vehicles attracted $480 billion.

Theories abound as to why the stock pickers have fared so poorly. Some blame the cheap money policies of central bankers for distorting fundamentals. Others note that markets seem to be driven by macro factors -- the direction of rates, the rise and fall of energy prices, worries about global growth -- rather than the earnings of individual companies.

“Most active managers focus on companies, not macroeconomics,” said Michael Rosen, chief investment officer at Angeles Investment Advisors in Los Angeles, where he helps oversee $30 billion. “There has not been a lot of reward for making distinctions among stocks.”

A report issued Thursday by S&P Dow Jones Indices painted an equally gloomy picture of the performance of active managers.

In the year ended June 30, 85 percent of large-cap stock funds, 88 percent of mid-cap funds and 89 percent of small-cap funds failed to match the major stock indexes they track: S&P 500 Index, the S&P Midcap 400 Index and the S&P Smallcap 600 Index. The numbers for five and 10 years were slightly worse.

“The numbers are pretty appalling,” said Aye Soe, senior director of global research at the S&P unit that compiled the report. “Given the choppiness in the markets we would have expected the active managers to come out looking better.”

Mutual funds with an international tilt fared somewhat better. Over the past year, 75 percent of global funds, 55 percent of international funds and 42 percent of emerging market funds failed to match indexes. Over 10 years roughly 80 percent of the funds trailed indexes.

Active managers may take comfort by looking at the past. The last time they trailed indexes this badly was in the late 1990s. In 1998 and 1999, according to Morningstar numbers, fewer than 8 percent of large-cap domestic stock funds beat the S&P 500 over the trailing five years. When the tech bubble burst in 2000, stock pickers began to do better. By 2003, roughly half were beating the index over five years.
Stephen Foley of the Financial Times also reports, Active managers exposed as most US equity funds lag behind market:
Nine out of ten US equity funds failed to beat the market over the past year, according to a new study that undermines active managers’ claims that they can outperform in more volatile markets.

The semi-annual report on fund manager returns, produced by S&P Global, has long been depressing reading for professional stockpickers, but the scale of the disappointment in the latest figures is likely to fuel further outflows from an industry that is already under pressure.

Money has been draining out of actively managed funds and moving into index-tracker funds at an accelerating pace this year.

The S&P Indices Versus Active (Spiva) scorecard shows that 90.2 per cent of the actively managed US mutual funds that invest in domestic equities were beaten by their benchmarks, when their returns are calculated net of fees.

There was not a single category of domestic fund — whether investing in large-caps, small-caps or a combination, or favouring growth stocks or value stocks — in which more than a quarter of managers succeeded in beating their category benchmark.

“There is nothing redeeming to say about the managers in the equity space,” said Aye Soe, global research director at S&P.

“They said they would provide downside protection and add value in choppy markets. This was their chance to prove themselves and earn their paychecks, but across every category they underperformed. It is embarrassing.”

The latest report covers the 12 months to June 30, which includes the summer 2015 market swoon, the rollercoaster markets of January and February and, after the Brexit vote, the late June sell-off.

It adds to a 14-year body of S&P data that confirms most US equities managers underperform the index, regardless of the category of fund and regardless of the timeframe. Over the past 10 years, 87.5 per cent of domestic equity funds underperformed.

Outside of US equities, however, it includes pockets of positive news. Stockpickers that specialise in emerging markets were more likely than not to beat an EM benchmark in the past year — only 42.2 per cent underperformed — and there were categories of fixed income fund where the average manager beat the index. The best of these were loan funds and municipal debt funds.

There is no evidence that the outperformance can be sustained even in those categories, however. On a ten-year view, 81.9 per cent of emerging markets funds and 74.4 per cent of muni funds are below their benchmarks.

Some $328bn flowed out of actively managed mutual funds in the US in the year to July 31, according to Morningstar, while $401bn flowed into funds that passively track an index, such as those run by Vanguard and BlackRock’s iShares division. The shift has accelerated throughout the year, and July was a record month for outflows from active US equity managers, the research group said.

The market share of passive funds has now passed one-third in the US, alarming some industry managers. With fewer investors analysing the value of a company before investing, critics say, the market’s role in efficiently allocating capital is being undermined. “If we push indexing to an extreme no one will get price signals,” said Matt Peron, head of equities at Northern Trust.

Executives at asset management companies with large active businesses say they can add value in many markets.

“I own some passive strategies, including Vanguard funds, personally,” said Tom Finke, chief executive of Barings, “but would you really take a $100bn pension fund and go all passive? There are areas where active is appropriate, especially for capacity constrained and less liquid strategies, but without a doubt there will be more encroachment from passive in many asset classes over time.”
On Wednesday, I went over the 2016 Delivering Alpha conference and mentioned a recent report by François Trahan and Stephen Gregory of Cornerstone Macro, where they state that times are about to get a whole lot tougher for active managers:
Ask nearly any investor (long only or hedge fund) and they will tell you it has been a difficult few years in the market. There are a plethora of reasons for this, but the central theme is the transition from the “Great Moderation” to the “Era Of Uncertainty.” This year, some of the blame has fallen on the divergence of the market (cyclical) from the structural issues in the global economy (China slowdown, Japan stagnation …). We recently presented our 4Q outlook which revolved around a peaking in PMIs and a recoupling of cyclical and structural forces. Regrettably … this recoupling doesn’t mean easy sailing for investors. A similar (though muted) backdrop in ’14 & ’15 were two of the worst years ever for active management.

Being risk aware will likely be the difference between success and failure over the next potential decade … just like it has been over the last three years. As such, today’s report focuses on “who’s most at risk” from a country perspective. We focused a significant portion of our call last week “Just As You Were Getting Comfortable With Cyclicality Things Are About To Change Yet Again” to the interconnectivity between a slowdown in the U.S. and the rest of the world. In today’s report, we put forth a framework to help investors gauge which countries are most at risk by looking at both top down and bottom up tools.
In my comment on Delivering Alpha 2016, I plugged the research at Cornerstone Macro, which is excellent and well worth paying for (there are other excellent investment research services covering macro themes but I like the way Cornerstone ties their research to markets).

I also plugged the blogs of Gerard MacDonell and Brian Romanchuk, two other former colleagues of mine from my days long ago at BCA Research (another excellent independent macro research firm here in Montreal).

The point I'm trying to make is this: macro trends matter a lot, especially in a ZIRP and NIRP world, and if you don't understand cyclical and structural trends, you're toast!

[Note: On my blog, I have an extensive blog roll with excellent blogs covering macro as well as a list of links to some excellent market research sites on the bottom right-hand side.]

So, should we be surprised that active managers are struggling in this environment? Of course not, when you have every major central bank levering its balance sheet to the tune of trillions of dollars, effectively backstopping markets, it's next to impossible to fight that big beta trend.

But take a step back here and keep this in mind, just like we had a major alpha bubble in the 90's right up to 2008, we're now seeing the makings of a major beta bubble prompted by retail and institutional investors dumping their expensive active funds and piling into cheaper exchange-traded funds (ETFs).

This is great news for Jack Bogle and the folks at Vanguard, as well as other ETF providers like BlackRock, but I recently alluded to the great American economist, Paul Samuelson, who once praised Burton Malkiel's A Random Walk Down Wall Street, but also worried about what happens when everyone jumps on the bandwagon and follows his advice (to only stick to low cost exchange-traded funds).

Why am I mentioning this? Because if you believe GMO's dire warning that the market is about 70% overvalued, then you should worry a lot about downside risk and focus on hedging your portfolio to protect against a big decline in markets.

Now, unlike Zero Hedge, I'm not a doomsayer, I don't think the sky is falling and that stocks are going to crash any time soon. I even take issue with GMO's liberal use of the Shiller P/E (see Gerard MacDonell's comment on Shiller CAPE, philosophically speaking).

And even though it's counterintuitive, I still think it's time to selectively plunge into stocks but you need to pick your spots carefully or risk getting destroyed.

In fact, when I analyze the portfolios of top funds every quarter,  I find tons of great stocks among their holdings but it's time-consuming and very difficult picking out the gems from the underperformers.

Still, just in the biotech sector (IBB and equally weighted XBI) that I like to trade, I've seen big moves off their lows in stocks like Aerie Pharmaceuticals (AERI), Clovis Oncology (CLVS) and Seattle Genetics (SGEN) and monster breakouts in stocks like CoLucid Pharmaceuticals (CLCD). [Celator Pharmaceuticals (CPXX) went from $1 to over $30 earlier this year in just 2 months before it got bought out.]

Admittedly, biotech is a sector that requires specialized knowledge and it's binary -- you can win big or lose your shirt (look at NVAX today)-- but it goes to show you that there are always stocks out there outperforming the overall market even when it's making record highs (click here to see stocks making 52-week highs and you'll see many more biotechs but also other companies from other sectors that have outperformed the overall market).

All this to say that good active managers are extremely rare and hard to find but they're out there and even in these central bank controlled markets, they're posting solid returns.

Another thing you should keep in mind, if my theory of a slowly forming beta bubble is right, you want to go to to work and find active managers who will add value when markets head south.

Of course, if the crisis in active management continues (and even if it doesn't), it only bolsters my case for large, well-governed DB plans that can invest directly in public and private markets all over the world.

In this environment, I believe large, well-governed defined-benefit pensions with a long-term focus have a structural advantage over traditional and alternative active managers who are pressured to deliver returns on a short-term basis.

So maybe the real crisis in active management will occur when investors realize they're tired of paying fees to underperfoming mutual funds, hedge funds and private equity funds, and prefer to invest in Canada's radical pensions which are once again being touted as the best pensions in the world. Wouldn't that be something, eh?

Below, buying the most under-owned stocks and shorting the most over-owned has proven a good strategy in recent years, according to Bank of America Merrill Lynch. Craig Johnson of Piper Jaffray and Dennis Davitt of Harvest Volatility Management discuss with Brian Sullivan.

And Peter Boockvar, The Lindsey Group reveals why he feels what is going on in Japan next week is the biggest risk to the US markets. This is just more nonsense on cracks in the bond market.

Lastly, CNBC's Meg Tirrell reports on the best biotech performers year-to-date. Sam Isaly, OrbiMed Advisors managing partner, shares his take on the biotech sector, including his bargain stock picks.

On that note, please take the time to contribute to this blog on the top right-hand side under my picture. I added three annual subscription options for retail investors ($50, $100, and $250 CAD) and separated this from my institutional subscription options (contact me for details). As always, anyone can donate at any amount at any time via PayPal by clicking the "donate" button to show their appreciation. Thank you!

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