Over recent months, we have noted how the economic and investing environment has regressed to the “Goldilocks” mix of slow-but-steady growth, low inflation, low rates and low market volatility that characterized the pre-Trump era.
Small caps are underperforming large caps, value stocks are underperforming growth stocks, and the 10-year Treasury yield has edged closer and closer to the 2% threshold.
It is all very 2015—with one important difference.
Stock Picking Has Been Paying Off
Active management has been paying off. According to data from Morningstar, only 26% of active U.S. stock funds beat their composite passive benchmarks during 2016. Over the 12 months through July 2017, however, 49% outperformed. Long/short equity hedge funds are also enjoying an excellent year. And these results are net of all fees and transaction costs.
One of the reasons that stock picking is making more of a difference for investors now is that correlation between stocks has collapsed. In the S&P 500, for example, correlation has gone from almost 70% at the beginning of 2016 to less than 30% today. Despite market-level volatility being very low, we are seeing rather high single-stock volatility and significant sector rotations.
In our view, the fundamental reason underlying this stock market behavior is that, for the first time since the financial crisis, the capital allocation process is being driven by company-specific factors rather than the macroeconomic factors that have prevailed over recent years, and the extreme “risk-on, risk-off” approach that investors adopted to navigate that environment.
The results have manifested as the delivery of meaningful excess returns versus the various market benchmarks over the last few months—a timely reminder, after many months of headlines pronouncing the demise of active management in the face of a seemingly unstoppable flow of funds into passive vehicles—that these performance trends have been cyclical rather than structural.
A Long Cycle in Favor of Passive
How often did we hear that the active management model was broken entirely, or, at best, only capable of outperforming in bear markets, or reliant on the systematic premia paid to holders of small-cap or value stocks? Recent outperformance by a growing proportion of managers, against a grinding bull market powered by large-cap growth stocks, lends support to the idea that talented stock pickers can outperform in a variety of conditions, as long as there is a willingness through the rest of the market to allocate capital in accordance with fundamental, company-specific views.
With that in mind, the recent long cycle in favor of passive is understandable given the macro-level risks that have overshadowed markets since the financial crisis, from the threat to the integrity of the euro, through the brinkmanship around the U.S. debt ceiling, to the constant background noise of quantitative easing and zero interest rates.
While these dynamics have not gone away entirely, there would always come a time when a critical mass of market participants became inured to them, and looked beyond them for information. We may have passed that threshold over the past 12 months, as central banks began to talk of reducing their balance sheets and “animal spirits” have been roused among corporate management around the world.
If so, this could be one of those inflection points that remind us that the seeds for outperformance by active managers may be sown while the market allocates its capital in ways that are divorced from company specifics or fundamental economic themes. They also remind us that, among the compelling reasons to invest only part of a portfolio passively, one is to create the flexibility to take genuine active risk elsewhere, with strategies that exhibit high levels of active share and single-stock conviction.
Abandoning active management can forego the opportunity to generate excess returns, as the stock pickers’ comeback of the past nine months has shown.
In Case You Missed It
- U.S. Producer Price Index: +0.2% in August month-over-month and 2.4% year-over-year
- U.S. Consumer Price Index: +0.4% in August month-over-month and +1.9% year-over-year (core CPI increased 0.2% month-over-month and 1.7% year-over-year)
- U.S. Retail Sales: -0.2% in August
What to Watch For
- Monday, 9/18:
- NAHB Housing Market Index
- Eurozone Consumer Price Index
- Tuesday, 9/19:
- U.S. Housing Starts and Building Permits
- Wednesday, 9/20:
- U.S. Existing Home Sales
- FOMC Meeting
Statistics on the Current State of the Market – as of September 15, 2017
|S&P 500 Index||1.6%||1.2%||13.3%|
|Russell 1000 Index||1.7%||1.2%||13.2%|
|Russell 1000 Growth Index||1.1%||0.8%||20.1%|
|Russell 1000 Value Index||2.2%||1.6%||6.5%|
|Russell 2000 Index||2.3%||1.9%||6.5%|
|MSCI World Index||1.2%||1.5%||15.6%|
|MSCI EAFE Index||0.6%||1.8%||19.6%|
|MSCI Emerging Markets Index||1.1%||1.4%||30.5%|
|STOXX Europe 600||0.9%||2.5%||22.3%|
|FTSE 100 Index||-2.2%||-2.8%||4.3%|
|CSI 300 Index||0.1%||0.3%||18.0%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||-0.2%||0.0%||0.7%|
|Citigroup 10-Year Treasury Index||-1.2%||-0.6%||3.4%|
|Bloomberg Barclays Municipal Bond Index||-0.3%||0.0%||5.2%|
|Bloomberg Barclays US Aggregate Bond Index||-0.5%||-0.2%||3.4%|
|Bloomberg Barclays Global Aggregate Index||-1.1%||0.0%||7.2%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.0%||0.2%||2.2%|
|BofA Merrill Lynch U.S. High Yield Index||0.2%||0.4%||6.5%|
|BofA Merrill Lynch Global High Yield Index||0.2%||0.7%||9.2%|
|JP Morgan EMBI Global Diversified Index||-0.2%||0.5%||9.5%|
|JP Morgan GBI-EM Global Diversified Index||-0.5%||1.2%||16.0%|
|U.S. Dollar per British Pounds||3.1%||5.5%||10.0%|
|U.S. Dollar per Euro||-0.5%||0.6%||13.4%|
|U.S. Dollar per Japanese Yen||-2.8%||-0.9%||5.0%|
|Real & Alternative Assets|
|Alerian MLP Index||1.1%||0.6%||-5.8%|
|FTSE EPRA/NAREIT North America Index||0.6%||1.9%||4.5%|
|FTSE EPRA/NAREIT Global Index||0.7%||2.1%||12.8%|
|Bloomberg Commodity Index||0.5%||0.7%||-2.1%|
|Gold (NYM $/ozt) Continuous Future||-1.9%||0.2%||15.1%|
|Crude Oil (NYM $/bbl) Continuous Future||5.1%||5.6%||-7.1%|
Source: FactSet, Neuberger Berman.