by Maz Jadallah
The past year has been one of the most difficult investing environments for high active share strategies since the financial crisis. In a nutshell, cheap money and accommodative central bank policy around the globe has artificially inflated both correlations and valuations in equity markets. The result is a dissipation in the relative valuation of bad companies compared to good companies, giving stock pickers a very hard time. For a more in depth look at the factors that have negatively impacted skilled managers’ abilities, please read the research note we published a few weeks ago – “Is Alpha Dead?”
The result is that active funds continue to lag the overall market. As the table below summarizes, over the past decade, active mutual funds have lagged their respective passive benchmark between 60% and 80% of the time depending on the category.
Active vs Passive Performance (%)
Table shows the over/under (blue/red) performance in each year for each Morningstar mutual fund category.
By contrast, the environment that prevailed in 2016 is tailor made for strategies that simply “buy the market” rather than attempting to pick winners and short or underweight losers. Shock prone markets that correct and reverse repeatedly need strategies that do exactly the same by virtue of being the same.
If you can’t beat them, join them. In 2016 investors stampeded out of active funds and into cheaper passive investment products. Through November, according to Bloomberg, investors withdrew $318 billion from active mutual funds, even more than last year, and the largest ever. Passive investing is in vogue and it shows
Perhaps astonishingly, despite the record outflows from active mutual funds, Vanguard, the shining beacon for passive investing, attracted $50 billion to their active funds last year. The firm manages over a $1 trillion in active strategies – amazing. Active isn’t dead – but high fees and inefficiency are.
Like Vanguard, we believe most investors should have exposure to both passive and active strategies in their portfolios making sure, however, to access active managers in the cheapest and most efficient way possible. Historically, that’s been easier said than done. But accessing active ideas efficiently and in a low cost way is at the heart of where active indexing and cloning seeks to add value in an investor’s portfolio.
Instead of active vs passive, an analysis of clone strategies vs passive benchmarks tells a very different story. Cloning has outperformed passive benchmarks twice as often (Small Cap and International) and three times as often (Large Cap) than the average mutual fund.
Cloning vs Passive Performance (%)
Table shows the over/under (blue/red) performance of long only indexes that utilize our clone score methodology to aggregate active investment ideas.
No matter the merits of a particular investment approach, no high active share strategy can outperform all the time. The data is clear, at some point, 100% of high-performing funds will underperform their benchmark over a one-year period and 97% will underperform over a 3-year period. If you’re going to invest in strategies that are different than the market – you’ll have to learn to be comfortable being wrong sometimes. See Baird’s note on “The Truth About Top Performing Money Managers” for some excellent research on the topic.
The period beginning August 2015 to December 2016 has been by far the most difficult relative performance period for our strategies. In 2016, with the exception of our Value Manager Index, all our strategies underperformed their broader market benchmark.
The bottom line is that institutional investors, and therefore our strategies, were caught wrong footed relative to the market – overweight in low returning sectors while underweight in some of the best performing sectors. The table below summarizes sector performance for the year compared to how each index is allocated (green color shows the largest allocation, yellow the smallest).
2016 Sector Performance vs Index Sector Allocations
Note how the Value Manager Index was the least allocated to the Healthcare sector. As a result, the index had the best relative 2016 performance of any Index or SMA Composite. The remaining indexes continued to follow the same investment themes they have the last couple of years and into the Presidential Elections in November:
- Bullish on healthcare although paring back on biotechnology stocks
- Bullish on technology stocks in the US as well as internationally with China tech names
- Bullish on services and consumer discretionary stocks
- Shifting from underweight in 2014/15 to more bullish in recent quarters on basic materials and energy stocks.
- Underweight banks and financial institutions but holding large REITs.
- Underweight non-discretionary stocks (consumer/industrial goods).
The surprise win by Donald Trump in the US Presidential election made some of the above investment themes look very uncertain. For example:
- Institutional investors were underweight financials, anticipating a “lower for longer” fed posture and the effects of new regulations on financial institutions. A good bet … until the surprise election result. Now the prevailing wisdom is the exact opposite – faster rate hikes and less regulation – regional banks and investment brokerages have rallied hard since the election, up 25% to 30% over the past 3 months.
- Managers were also largely overweight technology names, which generate a big part of their revenues in overseas markets, only to be impacted negatively by concerns around the impact of potential changes in US trade policies. Technology stocks are the third worst performing sector over the past three months returning just 1%.
Besides the long positioning in our strategies, our dynamic hedge which is employed in three of five SMA Composites and two of five indexes was triggered during the first three months of 2016. The hedge detracted from performance in the case of our APHACLN Index and the Select and Momentum SMA Composites but added to performance in our International strategies (both the index and the SMA composite). For a deeper look at the performance of the dynamic hedge relative to our Hedge Fund and International indexes, please read our research note, “A Tale of Two Hedges.”
Difficult as 2016 was for our strategies, over a longer time horizon, our performance has held up well. As the performance table above illustrates, all five index strategies outperformed their appropriate benchmarks over the 5 and 10 year periods. Our hedged strategies easily outperform the Morningstar Long/Short Equity category, while our long only strategies outperform the S&P 500, an accomplishment that only 5% of US Domestic mutual funds have been able to achieve. See S&P Dow Jones Indices SPIVA Scorecard.
If we’ve learned anything over the past year, it is that the “active indexing” approach we’re pioneering at AlphaClone is the future of active investing – one that reinvents how investors access active investment ideas. We believe there is no better, more efficient, lower cost way to access investment ideas from skilled managers over time.
We’ve also learned a lot about our products strengths and weaknesses during the year and perhaps most importantly, we’ve learned a lot about how our clients are using our products in their portfolios and the expectations they have as a result. Our goal and mission in 2017 and beyond will be to incorporate that learning into the products and services we bring to market and into how we support our clients.
A new portfolio service we’re developing is a good example of how we’re applying lessons learned and giving investors powerful ways to incorporate our products. The service offers individual investors saving for retirement a diversified investment portfolio developed based on our philosophy that both passive and efficient active strategies belong side-by-side in the same portfolio. The idea is simple: use ETFs and in some cases mutual funds to build a diversified retirement portfolio that matches a client’s investment objectives and risk tolerance. Each asset class allocation within the “AlphaClone Mirror Portfolio” will have both a passive and “high active share” component thus combining the best of both passive with high active share strategies that are relatively low cost and efficient (see illustration below).
We’ll be writing a lot more about this service when we launch it later this year. Until then, we’re looking forward to what 2017 will bring as we continue to support our clients and strategies in the market. Please don’t hesitate to reach out if you have questions or comments.