When Volatility Rises, So Have Active Management Relative Results
“The past five years have been marked by the rare combination of a remarkable rebound in domestic equity markets and a low-volatility equity environment. This combination has proven to be difficult for domestic equity managers, as over 70% of them across all capitalization and style categories failed to deliver returns higher than their respective benchmarks.” This is the conclusion of the most recent publication of the S&P Dow Jones Indices report, “S&P Index Versus Active” (SPIVA). The piece stoked our curiosity about the relationship between volatility, the recent relative performance of active managers, and the indexes they for the most part have struggled to beat. For those who may be unfamiliar with this report, the SPIVA Scorecard has served as the de facto scorekeeper of the active versus passive debate since its initial publication 11 years ago. The scorecard presents one-, three-, and five-year annualized returns of active equity and fixed income funds across all asset classes versus their corresponding S&P index. The results are based on a rich data set consisting of the S&P Dow Jones Indexes and CRSP (Center for Research in Security Prices) data. The scorecard also consistently addresses issues related to measurement techniques, universe composition, and fund survivorship.
According to the 2014 Mid-Year report, over the last 12 months (periods ended 6/30/14), 59.8% of large-cap managers, 57.8% of mid-cap managers, and 72.8% of small-cap managers underperformed their respective benchmarks. These results led us to further explore the relationship between the performance of active managers and low-volatility environments.
Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced.
At Royce we have always viewed volatility as an ally; as Warren Buffett said, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” So while many investors think volatility is synonymous (or nearly so) with risk, we have never seen it that way. Far from seeing the challenge of managing risk as avoiding volatility, we try to take advantage of market movements—an essential skill for any successful active manager. Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.
Because of our commitment to this core principle, we were eager to test the hypothesis of the SPIVA Scorecard. We ran our own study focused on the small-cap space to determine what, if any, relationship exists between volatility and outperformance among active small-cap managers. Although there are many measures of volatility, we chose in our study to use standard deviation, looking at monthly rolling 12-month standard deviations from the inception of the Russell 2000 Index on 12/31/78 through 9/30/14. This gave us 418 data points spanning more than 35 years.
We began by sorting the annual standard deviations from highest to lowest and divided them into quintiles. For each 12-month rolling period in each quintile we looked at the corresponding outperformance of the active small-cap manager versus the Russell 2000. We used the Morningstar Category Average for US Open End Small Blend funds as our proxy for the average active small-cap manager. Our results, shown in the following table, were nothing short of astounding.
Volatility and Small-Cap Performance Spread (%)
Average of Monthly Rolling 12-Month Statistics from 12/31/78 through 9/30/14
|RUSSELL 2000 AVERAGE|
|AVERAGE ACTIVE U.S. SMALL-CAP|
MANAGER SPREAD1 VS. RUSSELL 2000
1 Average of all funds in the US Open End Small Blend Category tracked by Morningstar with at least 12 months of history as of the relevant month end. Source: Morningstar Direct
We found that, on average, active management underperforms the benchmark during periods of lower volatility. The average standard deviation of the Russell 2000 in the lowest quintile of volatility was 10.80% and, correspondingly for all the return periods in this quintile, active managers underperformed the benchmark on average by 50 basis points. The second-lowest quintile by volatility saw the standard deviation of the Russell 2000 average 14.35% while active management underperformed on average by 25 basis points.
Yet as volatility increases, we see a corresponding—and marked—relative performance advantage for active managers (again, as measured by the Morningstar Small Blend Category Average). We found the widest outperformance spread in the highest quintile of volatility—222 basis points of outperformance where the average annual standard deviation for the Russell 2000 was 29.29%. Active management also had an advantage in the fourth quintile of volatility. In this quintile, the average annual standard deviation for the Russell 2000 was 21.53% and active management owned 198 basis points of average outperformance.
In what has been a low volatility environment, the most recent 12-month annual standard deviation was 14.64%, which places it historically inside the second quintile. We further found that the 12-month annual standard deviations have been stuck in the first or second quintile range since the period (10/1/11-9/30/12) through 9/30/14. Needless to say, it has been a highly challenging market for active managers, many of whom (including us) typically rely on volatility to find the mispricing they need to outperform.
It is certainly true that over certain time periods, equity indexes (and the passive funds that track them) will do better than most active managers. And in many instances benchmark indexes have been outperforming relevant peer groups of active managers over 12-month periods. However, underperformance can be driven by a host of factors, including volatility. These reasons often extend beyond the stock-picking acumen of the respective managers and may be specific to particular funds and/or approaches. In this, Royce is no exception.
Looking back at our more than 40 years of investment experience, we think there can be little argument that active managers have the potential to achieve benchmark-beating long-term returns. What this mid-year SPIVA study and our own research suggest is that the ideal environment for active management is one in which securities are more likely to be mispriced and markets are less efficient. Using history as our guide, we find that volatility is cyclical. It seems likely that as those market gyrations return, the opportunity for active managers to shine will also.