Last month’s market crunch was the biggest test for stockpickers since the global financial crisis – and the evidence is growing that they flunked it.
In recent years, active managers have consistently failed to beat benchmarks, often blaming historically low levels of volatility and dispersion between sectors. Stocks have tended to rise or fall gently in unison, making it hard for stockpickers to find an edge that would justify the higher fees they charge.
No such excuses were possible in the first quarter of this year, with volatility going through the roof amid the COVID-19 crisis and sectoral dispersion, at least on Wall Street, rocketing above levels last seen at the peak of the global financial crisis. Oil companies, miners and banks plummeted, while health care, telecoms and software companies held up much better.
But in this theoretically target-rich environment, stockpickers performed even worse, undershooting their respective benchmarks by some of the largest margins on record.
“This tells us that the [stockpicking] industry is built on a myth and that myth has been torn to shreds,” says Alan Miller, chief investment officer at SCM Direct, a London-based wealth manager that invests only in passive funds.
Active managers had been telling clients that the extra fees they charge would pay off in a downturn, he says. “It turns out the opposite is true.”
An analysis of 1,350 funds with combined assets of US$4-trillion by Copley Fund Research shows that U.S. equity funds underperformed equivalent passive funds by 1.44 percentage points, net of fees, in the first quarter of 2020. That was the worst showing in four years and the second worst since 2012.
Emerging-market equity funds undershot by 1.36 percentage points, the second-worst relative performance since 2008. In absolute terms, U.S. equity funds lost 20.9 per cent on average, according to Copley, with emerging-market funds slumping by 25 per cent.
Separate analysis by SCM Direct of 627 Britain-domiciled equity funds found those investing in British stocks underperformed the FTSE All-Share Index by 2.8 percentage points in the first quarter. U.S., emerging-market and Japan funds also fell short while European funds kept pace with the benchmark.
Copley’s analysis points to wrinkles that may explain active managers’ poor showing.
Funds looking to shield investors from the worst of the sell-off by rotating into cheaper stocks – traditionally viewed as more defensive – were caught out. “Growth” stocks, companies with fast-growing revenue or earnings, outperformed these “value” stocks, which are judged to be cheap against earnings or assets, by the largest margin since 2017. This was largely due to the relative strength of the likes of Apple Inc. (AAPL-Q), Microsoft Corp. (MSFT-Q) and Alibaba Group Holding Ltd. (BABA-N), which were mostly underweighted by active funds.
Stocks promising high levels of earnings growth are doing well “despite the overall ugliness of the market,” says Steven Holden, Copley’s chief executive officer.
Most emerging0market funds, meanwhile, went into the crisis with big underweighted positions in China – the one big market to have held up reasonably well during the quarter, dropping slightly more than 10 per cent.
Geoff Dennis, an independent commentator, says the first quarter became a “perfect storm” for emerging-market stockpickers, which tended to be constantly underweighted in China as they tried to adjust to its ever-increasing clout in indexes. The country’s weighting in the benchmark MSCI Emerging Markets Index, for example – including stocks listed in Hong Kong and the U.S. – is now slightly less than 40 per cent and likely to increase further in the next reshuffle.
These active managers are also wary of having such a large proportion of their assets in one country, particularly given worries over the transparency of China’s corporate and economic data, and would not have expected it to outperform given its central role in the coronavirus crisis.
Moreover, Mr. Dennis says these stockpickers were not positioned for a broad sell-off because emerging markets had undershot developed markets in 2019 and there was “a fairly widespread view early in the year that emerging markets would beat developed markets in 2020.”
Active managers can argue that one quarter’s data are not enough on which to be judged. Mr. Holden says stockpickers could salvage their reputations in the months ahead – as happened after the global financial crisis.
But others are less convinced. Robin Powell, editor of The Evidence-Based Investor blog, says active managers “are always asking for time. ‘Just be patient,’ they tell us, and ‘things will change.’”
But that appeal, Mr. Powell adds, was based on the promise of outperformance in a bear market and the return of volatility.
“They’ve had both of those things in recent weeks, yet they still blew it,” he says. “This was their big chance to prove their worth – and they failed to take it.”
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