Active Management Archives — Page 4 of 6

Is it Value’s Turn?

This week we examine factor performance from the Russell 1000, with a focus on the dynamic between growth and value stocks. For the month of July, value finally pulled ahead of growth as a contributor to performance. This is a shift from recent behavior as growth leads on a trailing 7-year basis. Typically, growth and value have operated in a cyclical relationship so value’s shift from detractor in 2Q to a positive contributor in July could signal a reversal in relative performance between the two styles.

Financials, particularly banks, did well in July by posting strong earnings; these tend to be value stocks and contributed to the relative outperformance. While tech has been a very strong performer year to date, some of the FANG stocks, namely Facebook and Netflix, hit potholes in July. Facebook encountered more trust and brand issues surrounding privacy and Netflix battled disappointing subscriber growth. These specific company pullbacks likely hurt the growth factor.

Growth has outperformed value since 2011 and the rolling 10-year outperformance is at a high point, now bumping up against two standard deviations from its long-term average. This paired with value’s recent edge above growth may indicate that growth’s outperformance versus value could be coming to an end.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Alpha Returned in 2017, But What About 2018?

Equity hedge strategies were the best performing hedge fund strategy in 2017, as alpha was generated on both the long and short side. This chart shows that net alpha bounced back nicely from 2016, as the 2017 environment was much better for active management. Alpha was generated on the short side during the first half of the year, but trailed off as the bull market continued to move higher.

Another factor that helped equity hedge strategies was the decline in correlations during the year. An environment with lower correlations among stocks is positive for active managers, particularly those who maintain both long and short positions.

For alpha generation to continue in 2018, correlations between stocks will need to stay low, with meaningful sector dispersion. Coupled with the continued effort to remove global monetary stimulus, we would expect managers to benefit from these conditions.

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Passive’s Influence on U.S. Small-Cap

This week’s chart examines the percentage of active and passive ownership within the large, mid, and small-cap segments of U.S. equities. The longstanding trend of increased investor usage of passive strategies over time has been well documented. Since January 2000, the percentage of passive investments has grown from 15% to represent nearly 47% of total U.S. equity mutual fund and ETF assets through June 2017. While true that the bulk of passive assets are directed towards informationally efficient areas of the market such as U.S. large-cap, the overall percentage of passive ownership within each market cap segment varies.

As seen in the above chart, passive investments comprise a greater percentage of the small-cap segment than those for mid or large-cap. Critics of passive investing argue that these investments have the potential to distort the price discovery mechanism of the market should passive assets become too large a percent of total invested assets. The reason for this being that strong passive flows provide support or pressure to index constituents depending on the direction of asset flow regardless of a company’s fundamentals. Given the higher overall percentage of passive ownership in small-cap, the impact of passive investing is arguably greater in this market cap segment.

The situation is further compounded for active managers in small-cap since approximately one-third of stocks in the Russell 2000 index do not generate earnings. Active managers generally have a quality bias thus tend to underweight companies that exhibit no earnings, have low trading volume, or short operating histories. Strong passive flows provide support to this segment of small-cap that is underrepresented by most active small-cap managers. Active small-cap managers in aggregate have been able to generate greater consistency of value-add over their index than active managers within the mid and large-cap market segments despite the higher percentage of passive assets. The reason for this discrepancy is likely because of informational inefficiencies which remain among small-cap companies. If the strong inflow trend continues in passive products, small-cap managers may experience greater difficulties outperforming their index in the future.

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Quantitative vs. Fundamental Strategies: Who Has the Edge?

How do performance trends differ between quantitative and fundamental strategies? This week we explore those differences amongst U.S. large, mid, and small cap equities over the past business cycle.

Quantitative and fundamental strategies first differ in their approach to selecting stocks. Quantitative strategies rely on mathematical models weighing a varying amount of factors while fundamental strategies rely on solid company standing, outlook, and a more human touch through proprietary analyst research.

Within the large cap universe, quantitative funds, on average, were unable to provide much downside protection during the financial crisis. However, over the course of the ensuing bull market these funds were able to outperform the benchmark and eventually their fundamental counterparts. This could perhaps be attributed to quantitative funds having a greater ability to react nimbly to any buy signals generated as a result of massive inflows into the large cap benchmarks in recent years. Strategies within the small cap universe experienced a scenario on the opposite end of the spectrum. Here, quantitative funds were able to offer neither superior upside nor downside protection versus the benchmark; on average these performed worse than the index and over the course of the bull market were unable to outperform enough to recoup those extra losses. As this universe of smaller companies has less analyst coverage, perhaps quantitative strategies struggled to capture enough readily available data from which their models could generate accurate signals. Strategies in the mid cap space exhibit an interesting pattern of their own. Quantitative strategies were able to protect on the downside along with fundamental strategies and were also able to outpace the outperformance of fundamentals.

While these patterns are certainly not guaranteed to persist through the next business cycle, they may offer insight into which universes quantitative strategies have either an advantage or disadvantage, whether it informational or reactionary. As quantitative strategies continually adapt through additions of new factors or tweaks to their models, it will be interesting to see how the two strategy types compare over the next business cycle.

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How Will Valuation Levels Normalize?

Active U.S. equity managers regularly point out that the stock market looks expensive, and as a result, they are having trouble finding good companies to buy. Our chart this week looks at the median P/E for the S&P 500 Index over the last decade compared to the current P/E (our E is based on trailing twelve months operating earnings). Not only does the broad index look expensive relative to history, but each of the sectors in the index also appears to be overpriced. But how overpriced? The green bars indicate the price correction needed to bring the index back in-line with the historic median P/E ratio. At current valuation levels it would take a full blown bear market (a price correction over 20%) before the market looks reasonably valued again.

However, there is another way for P/E multiples to normalize over time; an increase in earnings without a change in price. The orange bars show the earnings growth needed to bring the index back in-line with historic valuation ratios. While 27% earnings growth for the S&P may seem optimistic, investors should realize that after seven straight quarters of negative earnings growth from 4Q14 to 2Q16, overall index level earnings are growing again. Year-over-year earnings growth hit 21% in 4Q16 and analysts currently expect S&P 500 earnings to be up 22.6% in 2017.

Lastly, astute observers will notice our analysis excludes two S&P sectors. Real Estate is excluded for a lack of historical data, as it just became a stand-alone sector back in 2016. Energy is excluded because energy sector earnings are currently so low the P/E multiple is essentially meaningless. But investors are expecting energy earnings to bounce back in 2017, and play a key role in driving overall S&P 500 index earnings growth.

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What Do Falling Correlations Mean for Active U.S. Equity Managers?

The Implied Correlation Index measures the average correlation of the stocks in the S&P 500 index. When the index is high, individual stocks are more likely to move in tandem with the broad index; when it is low, return dispersion among stocks in the index will be higher.

Looking at the 1 year chart above, the correlation downtrend is easily visible. With low correlation levels, opportunities should be present for active managers to find alpha and begin outperforming their benchmarks once again. With higher return dispersion, active managers will have an increased opportunity to pick winning stocks. If correlations continue this pattern, it should be easier to identify successful active managers rather than those who have ridden the macro trends of the market in recent years. If nothing else, falling correlations within the index provide an opportunity for active managers to recover from general underperformance versus the benchmark which has plagued them in recent years.

Are Quant Strategies Poised to Replace Fundamental Managers?

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes – let alone capturing any alpha – was incredibly challenging.

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes — let alone capturing any alpha — was incredibly challenging.

Notably, quantitative strategies seemed to have an easier time reacting to these events than fundamental strategies. Quantitative, or “quant,” strategies rely heavily on statistical and mathematical screens and indicators which largely remove human emotion and judgment from the equation. These models arguably enabled portfolios to recognize the surprise market events of 2016 and adapt much more quickly than fundamental strategies. However, while quant strategies largely proved successful relative to their fundamental counterparts in 2016 during an array of smaller disruptive events, this pattern is not proven to hold during severe inflection points.

Will Investors Continue to Move Away from Active U.S. Equity Strategies?

This week’s chart shows asset flows between active and passively managed mutual funds and exchange traded funds (ETFs) in U.S. equities. Over the last eleven calendar years, active strategies experienced cumulative outflows totaling $864 billion, while passive strategies saw inflows of nearly $460 billion.

Strong passive flows such as this can potentially have a negative effect on active performance since stocks are less able to differentiate themselves on fundamental factors. When passive strategies receive significant inflows, all stocks in an index are purchased and receive price support. This can have a material impact on stocks with limited trading volume, thus this is more of an issue for small-cap versus mid or large-cap. Within small-cap, passive inflows in 2016 totaled $7.6 billion while active outflows totaled $18.5 billion. The Russell 2000 Value posted the strongest return within the nine U.S. equity style boxes during 2016, while active strategy outperformance in small-cap value was especially challenged relative to the other style boxes.

With passive U.S. equity indices ranking in the top half or better of their respective peer groups in recent years, active strategies have largely lagged behind their benchmarks. This performance lag is a primary reason why asset flows have shifted to passive strategies. Since a passive strategy essentially owns the market, passive allocations have fully participated in the current bull market, while active strategy performance depends on how a particular fund’s bets fared relative to its benchmark. Passive investing represents a low-cost means of gaining exposure to an asset class and fees are often a small fraction of the fees paid for active management. With valuations at or close to all-time highs, active manager performance will be closely monitored in 2017 to see if their higher fees are justified in this current market environment.

Are Active U.S. Equity Managers Poised for a Rebound Heading into 2017?

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.¹ A lower measure signals to investors that sectors and styles in the S&P 500 have started to move independently after years of volatility and tighter correlation. This environment should allow active managers to generate alpha, as stock selection plays a key role in outperformance. As this trend continues, managers can focus on bottom-up fundamentals (i.e., company valuations) and less on macro-economic events that could cause dispersion within the asset class. For active managers, dispersion is critical because it allows them more opportunity to select winners and losers and thus outperform the indices against which they are measured. For investors with large allocations to actively managed U.S. equity portfolios, this is good news heading into the New Year.

¹The Implied Correlation Index measures correlation on a scale of -100 to 100, rather than the mathematical scale which is between -1 and 1.

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