Another Lost Year for Active Management
By Chris Maxey, Ryan Davis
January 8, 2013
Stocks Surge On Fiscal Cliff Deal
Equity markets surged last week amid a fiscal cliff agreement passed by Congress. The S&P 500 rose 4.6% during the week, the biggest gain since December 2011, while the Dow Jones Industrial Average gained 3.9%. On Friday, the S&P 500 reached a five-year high index level of 1466.47.
Congress approved a package of new tax provisions on Wednesday in a bid to avert the so-called “fiscal cliff,” which was technically breached on Tuesday. The agreement raised income tax rates for Americans making more than $400,000 ($450,000 for couples), while permanently extending the Bush-era tax rates for lower and middle class citizens. Taxes on investment income, including capital gains and dividends, also increased for higher-bracket taxpayers.
Unfortunately, a more comprehensive deal regarding the automatic spending cuts known as sequestration was not reached. The legislature delayed the cuts until March 1, setting up another potential fight between Democrats and Republicans in late February. Debate will also center on the debt ceiling, which the US hit in late December. The Treasury Department is currently using stopgap measures to prevent increases in government debt, but those actions only create about two months of capacity before Congress must raise the US borrowing limit.
Many market participants were surprised by the December Federal Open Market Committee (FOMC) meeting minutes, in which several members voiced concern about continuing asset-purchasing programs past 2013. While there was general agreement that the programs were supportive of growth, “they also generally saw that the benefits of ongoing purchases were uncertain and that the potential costs could rise as the size of the balance sheet increased." The group also expressed concern about their ability to withdraw said policy accommodations.
The Treasury market sold off following the release of the meeting transcript, with the yield on the 10-year Treasury reaching 1.91% on Thursday. This was more than 20 bps higher than where the 10-year started the week. With interest rates now also formally tied to unemployment, investors may be starting to contemplate a world free of easy money policy for the first time in years.
Despite the backup in Treasury rates, high yield bonds continued to trade higher last week in the wake of Congress’ agreement. Yields on high yield bonds, as represented by Barclays data, traded below 6% for the first time in history last Thursday after declining to 5.9%. This is 220 bps lower than levels from just 12 months ago. The average junk bond traded at $105.25, the third highest level in 10 years, according to the Wall Street Journal.
A spate of important economic indicators were released last week, headlined by the government jobs report released on Friday.
The Institute of Supply Management released its two important indicators last week, the manufacturing and non-manufacturing indices. Both metrics are important barometers of the health of the US economy.
The ISM manufacturing index rebounded to 50.7 in December following a brief dip into contractionary territory, most likely spurred by Hurricane Sandy. Seven of the 10 underlying components of the index improved in December, although the all-important new orders index was unchanged from the prior month. At 50.3, the new orders reading indicates tepid levels of future growth for US manufacturers.
The non-manufacturing index was much more robust. The index reached 56.1 in December, its highest reading since February and well above expectations for a level of 54.5. New orders were very strong, reaching 59.3, while a measure of business activity remained over the 60 mark. The employment component also experienced a solid gain of 6 points to reach 56.3.
The non-manufacturing index is arguably the more important of the two ISM reports because of the relative size of the American service economy. This makes for encouraging news for investors, as Friday’s release indicates a very healthy state of production in the country’s service sector.
The Bureau of Labor Statistics reported on Friday that nonfarm payrolls expanded by 155,000 in December, about on pace with the rate of gains seen for all of 2012. The prior two months were revised upward by a net 14,000. Gains were concentrated in the health care, food services & drinking places, construction, and manufacturing sectors. The average workweek and hourly wage also increased during the month, indicating labor demand is firming.
The unemployment rate remained steady at 7.8%, after November’s rate was revised slightly higher. The agency revises data from the household survey (from which the unemployment rate is calculated) at the end of each calendar year based on updated seasonal adjustment factors. Only November (increased by 0.1%) and July (decreased by 0.1%) were affected by this process. A broader measure of unemployment known as underemployment – which adds discouraged workers and temporary workers who prefer to be full time to the traditional measure – remained unchanged at 14.4%.
While unspectacular, the labor market continues to manufacture steady, consistent gains. Following a soft patch in the middle of the year when the economy only added 200,000 jobs over three months, nonfarm payrolls have increased by an average 160,000 over the past six months. Meanwhile, the unemployment rate has steadily crept down, a full 0.7% lower than 12 months ago (albeit with a labor force participation ratio that is 0.4% lower).
Another Lost Year For Active Management
There is no doubt that 2012 will be remembered by many investors, for reasons both good and otherwise. One group less likely to remember the good of 2012 is active managers. Across the universe of hedge funds and mutual funds, relatively few were able to outperform their comparative benchmarks. This continues a long running trend of active managers lagging their less active counterparts and raises many questions about the efficacy of active management.
For the year, the S&P 500 returned 16%. According to Goldman Sachs, 35% of large cap core managers beat the S&P and a mere 20% of large value managers did the same. In small cap, where the Russell 2000 Index returned 16.3%, only 33% of small core managers outperformed.
Why was the investing climate so unfavorable for active managers? For starters, the 16% gain posted by the S&P 500 was not a straight line higher. After gaining more than 12.5% in the first quarter, the S&P quickly gave back 6% in May. That was followed by a 6% gain in the third quarter and slight losses over a fiscal cliff-influenced volatile fourth quarter.
Goldman Sachs also pointed out that abrupt sector rotations proved very difficult for most managers. Financials led the way up in the first quarter, but also led the way down in the second; it once again turned out to be the top performing sector over the back half of the year. In total, four sectors (Financials, Tech, Consumer Discretionary, and Health Care) represented three-quarters of the S&P’s gain.
Source: Goldman Sachs
Active managers were not the only ones to struggle in 2012. Bespoke Investment Group compiled year-end 2012 price targets from major Wall Street strategists at the beginning of 2012. At that time, strategists expected the S&P 500 to finish at 1344. By the start of the fall, after the S&P had already booked most of its gains for the year, strategists were still expecting the S&P to close at 1386. In the end, the S&P closed at 1402, or more than 4% above where the consensus anticipated.
Regardless of any number of excuses one could concoct, investors’ opinions are the only ones that matter, and they are sending a very clear message. Estimates from the Wall Street Journal show that investors pulled $119 billion from US equity mutual funds through November 2012 in the YTD period. That follows a similar pattern in 2011. A lot of that money is finding its way into exchange traded funds (ETFs) that offer passive investments at a much lower cost.
Source: Wall Street Journal
But, there are a handful of reasons to think active managers can do a better job in 2013. In the post-2008 era, markets have largely taken their cues from macro events – Europe, the debt ceiling, the fiscal cliff, slower growth in China, and so on.
It appears those influences are gradually diminishing. In summer 2011, the average 30-day correlation between S&P 500 constituents spiked to 0.9. During the latest round of fiscal cliff concerns, correlations rose to slightly more than 0.6. The trend for correlations has clearly been down in the last 18 months and if that holds up, managers with an ability to differentiate between good and bad stocks should do better.
Volatility is tracking on a similar path. In the month of May, 30-day realized volatility spiked to near 40% annualized, but over the full year, the S&P 30-day realized volatility averaged 23%.
With the ETF-ization of investments in the last decade, it is highly unlikely that active managers will ever return to their previous heyday. Some will continue to be successful, but, for many investors, the solution is to find an appropriate mix of ETFs and complement them with those true alpha generators. This year will be another important one for active managers to prove their worth and there are reasons to think that some should be more successful.
the week ahead
The first full week of the New Year brings a limited number of economic reports. Data on international trade and the National Federation of Independent Business’ (NFIB) Small Business Optimism Index are the most notable.
Earnings season officially kicks off with fourth quarter results from Alcoa on Tuesday. Analysts expect the aluminum producer to
report an increase in earnings but a fall in revenue. Other major earnings reports are due from Monsanto and Wells Fargo.
Several central banks meet this week, including the ECB and Bank of England – both of which are expected to keep monetary policy unchanged. Other banks meeting include Romania, Poland, Russia, Thailand, Indonesia, Peru, and South Korea.
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