Active equity fund managers are staging a comeback. After years of underperformance, during which active managers lost tens of billions of dollars in assets to passive funds, during the first half of this year, over half of all US equity mutual funds outperformed their benchmarks, according to the latest flagship scorecard from SPDJI. Equity hedge funds are also doing well, gaining an average of 8.6% this year to the end of September, according to HFR. This is the strongest performance in four years from the equity hedge fund group.
US equity funds returned an average of 18.7% in the 12 months to the end of June, surpassing the broad S&P 1,500 index’s total returns of 18.1%, according to SPDJ’s report on active equity fund managers. According to an analysis by the FT, this translates into 52.5% of all funds beating their benchmarks, compared to an outperformance record of only 15% for the past decade.
Falling equity correlations have been blamed for this strong showing from active equity managers. As the Federal Reserve has embarked on its mission to try and normalize monetary policy, equity correlations have fallen, helping active stock pickers.
Equity correlations have slumped across the board this year. The decline has been so aggressive that Bernstein analysts have termed it “The Great Correlation Collapse”. Indeed, according to Morgan Stanley, the realized correlation of the US equity benchmark’s constituents is about 18%, down from roughly 60% just a year ago and one of the lowest readings since 2001.
The Great Correlation Collapse
The Great Correlation Collapse is helping active equity fund managers profit from individual equity themes such a rate rises, which would have been difficult to plan this time last year. A recent research note from analysts at Bank of America notes that rate sensitive equities, such as Financials, Utilities, and Telcos have seen correlations to rates rise substantially in recent months. For example, the correlation between the 10Y and US Financials has risen from around -0.55 over the past two years, to -0.75 in the last three months. BoA's analysts calculate that a 10bp increase in the 10Y rate would translate on average to a 1.6% gain for Financials and a 0.9% loss for Utilities. Energy, Telcos, and Industrials could also benefit.
However, while equity correlations have fallen, dispersion has increased.
A recent article from analysts at Morningstar reports that equity dispersion -- the gap between the strongest performers versus the weakest -- has gradually dropped and is now at a level not seen in the past 20 years. By assessing 47 key country markets and the gap between the 10th and 90th percentiles over five-year rolling periods, Morningstar calculates that the range of outcomes is only 13% today versus as high as 40% in 1998.
All of the above points to the conclusion that while active equity fund managers now have the opportunity to deploy their skill and experience stock picking, the chances of picking a stock that goes on to achieve market-beating returns is slim.
It's no surprise then that the majority of equity hedge fund gains this year have come from a few key stocks, notably, the FANG complex. Two months ago Goldman Sachs' Hedge Fund Trend Monitor report noted:
"The average equity hedge fund has posted a 7% YTD return, benefiting from large allocations to growth stocks and the Info Tech sector despite low volatility and dispersion...Our Hedge Fund VIP list of the most popular long positions has outperformed the S&P 500 by 725 bp YTD. The VIP list contains the 50 stocks that appear most often among the top 10 holdings of fundamentally-driven hedge fund portfolios. The basket has maintained its 2H 2016 momentum into 2017, benefitting in particular from its concentration in high-flying tech stocks. The list’s top 10 stocks include FB, AMZN, GOOGL, BABA, MSFT, and AAPL."
Is this stock picking skill or just momentum trading?
Active Equity Fund Managers Dilemma: Momentum
A new report from analysts at Nomura suggests that it is the latter. Specifically, the report notes "2017 has been a good year for active equity fund managers...This outperformance is likely being driven by high exposure to momentum." It goes on, "funds this year have “passively gained” large momentum tilts because, given low turnover, when funds outperform, the overweight stocks in the fund become high-momentum stocks that are continuously held for an extended period of time."
According to the analysts, the average portfolio turnover rate of mutual funds is now considerably lower than a decade ago, as funds concentrate on their best ideas. By the end of 2016, the asset-weighted turnover ratio of large-cap funds was below 40% and the simple average turnover ratio was around 60% -- the lowest levels recorded since 2001. What's more, "across all U.S. equity mutual funds, the asset-weighted expense ratio was 0.64% and the turnover ratio was 36% at the end of 2016; both were well below their long-term averages."
So far, the momentum tilt has helped active equity fund managers outperform as they've been able to stick with the market's biggest winners, Amazon, Facebook, Apple and Netflix. However, the dilemma is that this success can breed its own "risk of underperformance due to momentum exposure." Once momentum collapses, funds severely underperform, as happened in March--April 2014.
"For active fund managers, the dilemma can be stated quite simply. Managers today are motivated to cut expenses and minimize turnover. But low turnover leads to the risk of an unintended—“passively gained”— momentum tilt developing in the portfolio, which, given infrequent rebalancing, sets the stage for funds to underperform. Success breeds its own risk. What is a boon to performance now can be a bane later."