January 5, 2009
What doesn’t kill you makes you stronger
As the following two exhibits show, there has been no place to hide in the long-only equity markets. On the sector front, every sector lost value, with the best of the bad news coming in Staples, losing only 15%. The spread between the best performing Staples sector and the worst performing Finance sector was a whopping 3,300 basis points. Sector allocations mattered big time in the past year. Not surprisingly, Finance was the worst performing sector in the first six months of the year, but the third quarter saw an unexpected recovery in Finance, rebounding a positive 2%, only to give it back in the fourth quarter with a 32% loss. The third quarter was surprising in other ways as well. For example, Chindia infrastructure sectors – Energy, Materials and Industrials—were the big losers, while Finance was a winner. It’s hard to figure out what was going on here, but it could be a reflection of de-leveraging and opportunity – harvesting gains and capitalizing on cheap Financials.
On the US style front, every style lost value, with the stuff in the middle surprising us by not performing in between. Mid cap has suffered more than large and small cap while large core has defended best, losing only 29%, versus 32% and 45% losses in large value and large growth, respectively. Our definition of “Core” is the stuff in the middle, between value and growth. Our style definitions are mutually exclusive and exhaustive, making them excellent for style analyses, both returns-based and holdings-based. Core tends to shine when investors lack conviction, unsure about which style to emphasize. We use Surz Styles and Countries throughout this commentary, as described in the Appendix.
By contrast, S&P shows Growth outperforming Value, while Russell shows just the opposite, Value outperforming Growth. Neither Russell nor S&P have Core, and this has distorted their results, so be forewarned. Any tilt toward core has benefited performance, so aggressive growth managers have done worse than typical growth managers, and ordinary value managers have done better than deep value managers. It’s easy to confuse style with skill but difficult to make good decisions once this mistake has been made. Comparisons and evaluations to off-the-shelf indexes only work on index huggers; for liberated managers we need to customize the benchmark by blending styles that are mutually exclusive and exhaustive. Also, peer group classification biases should be particularly pronounced in year-to-date performance rankings, with most value managers outperforming their indexes and most growth managers trailing their indexes. This is not skill, or lack thereof. It is style.
Fleeing the country has only made things worse, especially in the second half of 2008, due primarily to a strengthening US dollar. Currency effects in the second half subtracted 13% from foreign market returns as the dollar strengthened. As the next exhibit shows, with the exceptions of Japan and Emerging Markets, every region lost about 45% in 2008, as did every style. Japan defended best in the year, losing only 24%, while Emerging Markets were decimated with a 51% loss – a 2,600 basis point spread. Overall, foreign markets lost 42% and EAFE lost somewhat more, declining 43%. Fleeing the country has not been a good move, supporting the claim that international diversification fails when it’s needed most. It is indeed a world market.
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