24 Apr Active managers in downturnsRead Time: 5 minutes
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It is often claimed that while it is all well and good being in an index fund when the market is rising, it is when things turn round that active managers can show their skill and avoid the falls while the dumb index investors watch their portfolios track the market all the way down. Obviously it would be nice to see how well this all worked over the last few weeks but unfortunately the data is not yet available so for now I will look instead at some longer term data – this has the advantage of covering a longer period and includes the rather significant fall in 2007-09.
US research house Standard & Poor’s (the same outfit behind the bond rating and the S&P 500 index, among others) publishes a regular scorecard called SPIVA (S&P Index Versus Active) which compares the performance of actively managed equity funds with their appropriate index benchmarks. It has been doing so since 2002, so covers a range of market conditions including the aforementioned 2007-09.
Although the SPIVA scorecard covers several regions, regrettably the UK is not one of them, at least not yet. However, the 10 countries that it does cover show a remarkable consistency between each other; given that the methodology is the same, this suggests that the data is not subject to systematic local variation.
The 2019 US scorecard can be seen on S&P’s website and reveals some interesting points about how funds actually performed.
First, let’s look at the years of the 2007-09 global financial crisis. I have extracted a few of the many data series in the report and the chart shows the proportion of US funds in each category which underperformed their benchmark in each calendar year from 2007 to 2009.
To provide some context, the first chart shows the MSCI World index over 2008, when the large fall occurred, and 2009 when, despite moving lower initially, markets began to recover.
The next chart shows some selected data series in terms of how, in the year before as well as those two years, they performed relative to appropriate benchmarks for each sector. Those benchmarks are stated in the SPIVA report. Being below 50% is good here.
In 2007, before the full impact of the crisis manifested itself in falling prices, only US small companies and US real estate funds were beating their benchmark in more than 50% of instances. When markets fell in 2007, the chances of owning a fund in the former sector which underperformed its benchmark increased to over 80% while in the latter, it rose to 70%. By a small margin, more than 50% of US equity funds managed to outperform their market that year, although the majority of emerging markets, international and global funds were all beaten by their respective benchmarks. In 2009, the general movement was upwards and small companies and real estate funds were back in outperformance territory. The majority of US equity funds as a whole, emerging markets, international and global funds were still underperforming however, the latter three having been remarkably consistent in that regard.
In the year of the worst fall, there was no material improvement in benchmark beating other than in the US equity sector and it reverted to underperformance when the recovery happened.
Still, as financial advisers are always telling their clients, nobody should invest in equity markets for this sort of period. Equities can subject the investor to a bumpy ride and is best undertaken over a timescale of one or more decades to provide a reasonable prospect of a return sufficient to compensate for the inherent risk of investing in them. Another of the data series in the SPIVA report covers the 15 years to the end of 2019 and I have extracted samples of three sets of data from this.
The first group shows that over a sustained period, the underperformance of funds in these sectors relative to their benchmarks is remarkably consistent over 15 years, the longest period for which data is provided.
The middle group shows the extent to which funds which existed at the start of that period were still around at the end – this is important when considering the average returns from a sector because funds are rarely closed for outperformance. Fund management is a business and if a fund fails to generate enough revenue for it to be economically viable, either because it did not attract enough capital from investors or its performance was lower than expected, it tends to be closed or merged with another one. Its record then disappears from the averages but those investors who did hold it will have experienced whatever returns it did produce while it existed. The effect of this survivorship bias is to boost the historic sector averages unless the data is adjusted to compensate for it – this is widely practiced in academic studies but not necessarily as much in the ‘research’ published by marketing departments, so it is important to establish whether research that you see has been so adjusted.
Finally there is style consistency – this is the extent to which a fund’s style classification (such as its exposure to large/small or to value/growth stocks) is the same at the end of the period as it was at the start. The big one here is how inconsistent the non-US developed market funds were and how consistent their real estate and emerging markets equivalents were. Since we know from the research of 2013 Nobel laureate Eugene Fama that style is a significant contributor to the return of a portfolio, investors will often select their component funds to provide exposure to specific style factors. If you select a small companies value fund because you specifically want that exposure, it is not necessarily helpful if it subsequently becomes a large companies growth one, particularly if you have already obtained that exposure elsewhere. The result can be a portfolio whose characteristics are significantly at odds with what was intended and that can impact on both risk and return.
What the SPIVA report regularly shows is how difficult it is to beat an appropriate benchmark even where an investment manager is helped by the demise of a significant proportion of funds over a long period and has the ability to switch the portfolio’s exposures to take advantage of apparent opportunities. The latter activity can be at the expense of the investor who wants to have some control over their exposures but ultimately the only way to ensure that is to invest in a portfolio which is not subject to style drifting and which you therefore know is constructed with your goals in mind rather than someone else’s.