We’ve never met an active manager that’s claimed they could beat the market every year.
Behind closed doors and away from the earshot of their investors, most managers will admit that their performance in the short-run often has more to do with whether their process is in vogue with the market or not.
What does that mean?
Consider the numerous tables of asset class returns that get published every quarter. A consistent take away is that no asset class out-performs in all market environments.
Similarly, no active strategy out-performs in all market environments.
Now, many studies have shown that there are numerous characteristics that can deliver superior risk-adjusted returns over time. The most popular include value, size, momentum, trend-following, quality, low-volatility and high yield.
Most active managers tend to align their portfolios one, or several, of these factors.
None of these characteristics, however, out-performs in all markets. In the short-run, their relative out-performance to the market can vary considerably.
A value tilt, for example, has historically delivered an average 2-year return premium of 547 basis points (“bp”) over the broad US equity market. In the short run, it has seen periods ranging between -4046bp and +5753bp.
Source: Kenneth French data library. Analysis by Newfound Research.
As we’ve said before, investors do not experience “average.” They experience under-performing the market by -40% over two years before they experience out-performing the market by 57%, assuming they did not sell and go to a different manager.
Before we explore why they vary, it is worth asking why these factors exist in the first place. Traditionally, answers fall in one of two camps: risk and behavioral.
The risk camp believes that the premium earned by an investor is compensation for bearing a certain market risk. For example, the premium earned by buying cheap stocks (the value factor) may be due to higher default probabilities; the premium earned by buying smaller-capitalization companies (the size factor) may be due to their relative illiquidity.
Holders of these securities therefore act like insurance companies: they bear the risk of the bad events and collect a premium for it. The open question is whether the premium earned is fair compensation for the risks (i.e. the expected value of loss from the risk being realized equals the premium) or whether the market has mispriced the risks, overpaying for protection because it overestimated the probability or the magnitude of the risks.
The behavioral camp argues that the premiums exist because investors exhibit behavioral biases that cause them to act irrationally. These irrational actions can be exploited by rational agents to generate return premiums. For example, loss aversion may account for the value premium, while over- and under-reaction may account for the momentum premium.
In either case, there is an argument for the existence of the premium. So why, then, do they vary so significantly over time?
Alpha is a zero-sum game. The excess return generated by one investor is at the detriment of another. The simple answer for why the premiums must be time-varying is that if they were not they would be viewed as free, which would cause an influx of investment, driving up prices and driving down forward return expectations to the point where there would be no premium.
In other words, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain.
While this may be a philosophical argument for why they must vary, it does not explain the mechanics of what causes them they vary.
We posit that the mechanics for why they vary is behavioral. It has been well established that investor flows tend to chase performance. Superior past performance is rewarded with new money inflows while inferior performance is punished by money outflows. The relationship between performance and flows has been documented as asymmetric and convex, with good performance leading to higher inflows and bad performance only leading to low outflows.
We believe premiums could be driven by this performance chasing behavior:
- Short-term out-performance of a factor attracts inflows.
- These inflows cause a short-term self-fulfilling cycle of further out-performance.
- Excess inflows cause return premiums to turn negative.
- Negative returns lead to out-flows.
- Out-flows cause a short-term self-fulfilling cycle of further out-flows.
- Excess out-flows cause return premiums to turn positive.
Based on this framework, those investors that sold their value managers in 1999 helped drive valuations even cheaper for the investors that held on. We can see this behavior manifested in price-to-book value for value stocks in the following graph from Research Affiliates:
The dot-com bubble peaked March 11th, 2000. At this point in the above graph, we can see that value stocks were trading at a significant discount to their long-term average price-to-book ratio. In other words, performance chasers who ditched value for the go-go growth stocks of the era only helped make value stocks more attractive.
When valuations reverted over the next several years, those that had the fortitude to stick with the allocation benefited to the detriment of those who folded.
Conversely, those who bought back in after the reversion – chasing the strong performance of value stocks – only bought in at elevated valuation levels, suppressing their forward expected returns.
The typical mutual fund equity investor holds a fund for an average of 3.3 years. That’s just long enough to buy after good performance, hold through a few years of suppressed performance, and sell. Go back to the graph on the first page and notice how the majority of the big premium swings too place over 2-to-4-year periods.
We believe this behavior drives the premiums of the styles themselves. Note in the graph (again, from Research Affiliates) that it is the out-of-favor funds (low inflows) that do best while the in-favor strategies (high inflows) do the worst.
We could very well be seeing cause-and-effect in action. Inflows have to be invested. The investment of inflows drives up prices. All else held equal, higher prices mean higher valuations. Higher valuations mean lower forward expected returns.
Most investors understand this logic already. They understand that stocks don’t always go up, despite having a long-term positive expected risk premium. They buy bonds, therefore, to diversify their exposure. They’ve seen the periodic table of asset class returns. They have internalized the benefits of asset class diversification.
Yet they don’t do the same with active managers. Value, size, quality, momentum, trend-following, low-volatility and high yield are all methods that have consistently demonstrated the ability to out-perform the market on a risk-adjusted basis over full market cycles. Yet investors continue to jump to the active strategy du jour, to their own detriment.
Staying put is easier said than done, of course. We can look at some popular factor tilt premiums over the last 20 years (1995-2015) and see that they went through significant and prolonged drawdowns relative to the S&P 500. Can we blame investors who gave up on a value tilt after under-performing the market by 31.90%? That relative drawdown, from peak-to-recovery, took 8 years.
|Annualized Premium||Relative Max Drawdown||Max Drawdown Length|
|Minimum Volatility||0.63%||-21.86%||13 years|
|Dividend Growth||2.45%||-29.52%||6 years|
Like asset classes, we are best off diversifying across active strategies and recognizing that active under-performance does not necessarily mean a strategy is broken, but rather that it is simply out of favor.
When a strategy is out of favor, we have to resist the temptation to fold. Otherwise, we only transfer the premium to investors who have the fortitude to endure.
Consider managed futures strategies. In a sweeping generalization, these strategies take a diversified, trend-following approach to a broad set of global asset classes, including equities, rates, and commodities. In 2008, when the S&P 500 was down -37%, the Societe General CTA and Trend indices were up 13.07% and 20.88% respectively.
Needless to say, the strategy came into vogue. It is worth noting that BarclaysHedge reportedoutflows in 2008 as investors scrambled to raise cash and significant inflows only later on in 2009.
As assets climbed, the approach suffered an extended 3-year drawdown from 2011 to 2014.
It was only when commodities began crashing in mid-2014 and the “long duration” trade materialized that managed futures were able to dig out of their hole. From June 2014 to April 2015 the SG Trend Index rallied over 30%.
Source: Societe Generale. Index results are hypothetical. The equity curves do not represent any strategy offered by Newfound Research. For more information, see https://cib.societegenerale.
Trend following seeks to take advantage of investor over- and under-reaction to new information. By systematically entering each and every emerging trend, trend following seeks to exploit market re-valuations that either do not happen quickly enough, or extend beyond fair value.
Like any other method that has historically demonstrated long-term out-performance potential, its premium must too vary over time. If not, and the premium were consistent, excess money would flow into the approach. Then, as trend followers tried to enter trades, they would make significant market impact, driving prices up (or down, depending on the direction of the trade), eating into their potential return. If the approach hit capacity, trades would drive price immediately to fair value, or even beyond, and the premium of the approach would converge towards zero.
So again, it is the weak hands that cannot stomach the volatility of the premium – those that sold out in 2012 or 2013 – that enable the strong hands to continue to benefit from the systematic approach.
The takeaway here is simple: whether value or trend following, active strategies that are tied to a specific premium will always vary in their performance. To reap their benefits over time, investors must treat them like an asset class in their portfolio: an allocation, not a trade.
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