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20.10.2016

Giselle Roux: How to invest when fund managers keep underperforming

That many active fund managers underperform the index against which they are measured is a fact, though the time frame over which this is judged can muddy the data. It has become routine for the monthly manager performance reports to try to explain why this is the case.

The most common factor nowadays is the claimed “bond proxy” rally. Unloved utilities, low-growth, higher-yield stocks and consumer staples have done better than the crowded sectors (healthcare, information technology, consumer discretionary) where most funds concentrated their efforts.

Adding to the pain has been a rally in energy and resource stocks, rarely an overweight allocation in a global portfolio. Hopes for a reprieve in the financial sector also came to naught.

Reasonably, growth equity managers point out these are not the kind of sectors that fit their criteria, that is, assessing a company’s longer-term growth potential. On the other hand, value managers blanch at the notion of paying the high multiples for stocks in the consumer staples sector.

It is solving the question of interest rates and the influence on asset values that should determine what happens in equity markets in the coming year. At one level, absolute and relative interest rates are the key influence on currency exchange levels and the flow of funds.

The direction of rates should reflect the expected change in economic momentum, though central banks have distorted much of what used to be normal.

The rise in US rates should have come as the economy showed signs of overheating; this time it is at the mature end of a weak cycle. While most equity markets are at or above their historic valuations, these macro factors can overwhelm company specifics.

A benign, but uninspiring, economic world with stable low rates may keep the bond proxy momentum alive.

As many have noted, equities have become a key source of portfolio income, rather than bond and credit markets. Stocks and sectors can remain overvalued for a considerable time and higher-yield stocks are likely to remain sticky as long as investors have faith in their capacity to pay the distributions.

But behind that lurks danger.

To the purist manager, which takes a traditional valuation approach, the argument of headline yield does not pass muster. Stocks’ prices are a function of their discounted future cash flow stream, and if the level or growth in cash flow is not sustainable, the distribution yield might be distorting. As evidence, the yield-driven parts of the markets are proving jumpy to any inkling of a change in the status quo.

Even if the bond proxy trade fades, it leaves global (and for that matter local) equity managers looking for a raison d’etre.

Truly long-term investors will see through momentum-driven markets, and that means they almost certainly will at times underperform. The evidence for their process falls on historical outcomes and crucially, the turnover in the portfolio. Frequently funds will indicate they are in for the long-haul, yet the portfolio changes are too rapid for the thesis to be proven.

This period of manager underachievement supports the contention that passive index trackers are the way to go. But be careful – is the problem the underperformance of the manager, or the period changing investment conditions that are driving the decision?

This recent experience suggests the combination of concentrated high-conviction managers with a passive base may be the best solution for investors reluctant to tack with the wind. In strong directional markets, the manager can be expected to do better than the index as stock selection can really matter.

When there is uncertainty, passive allocation removes all the judgment on market conditions. It won’t make you more money than the market, but at least it removes the worry of relative performance and fees in a time of low returns.

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