Tuesday, November 16, 2010

Active Managers Struggle Against their Benchmarks

Quantitative strategist Savita Subramanian of Merrill Lynch is out this morning with an interesting report on the performance of equity managers.

According to Savita, only 1 of 5 active equity managers are outperforming their benchmark so far in 2010 (full disclosure: yours truly is lagging the S&P modestly YTD). There have been a couple of problems.

First, as some of my previous posts have mentioned, there has been a very high correlation between stock price movements. This has meant that fundamental analysis has not really been able to add much value, since stocks have all moved in the same direction.

This has meant that the bulk of outperformance for a manager has been based on the "beta trade". That is, if you're quick to jump on lower quality, more volatile stocks when prices are moving higher, you have the chance to outperform - but you also have to be smart enough to reduce beta before the market tumbles. Most managers are not "wired" to do this (including, again, moi).

The second issue with the market indices, according to Savita, has been the fact that low priced stocks have been driving benchmark returns. Her work indicates that:

Roughly a quarter of the value benchmark returns have been contributed by the lowest priced stocks, a disproportionate amount given that these companies represent only about a tenth of the benchmark by weight.
There's some good news for me and my fellow equity mangers, however. Savita continues:

Generally periods like today are followed by markets during which stock selection strategies outperform. The last time correlations were as high and spreads as low was in 1987, and the subsequent years saw fundamentally based stock selection strategies outperform. In particular, stocks with attractive valuation by earnings and cash flow led by a wide margin. This bodes well for active managers in 2011 and we are already starting to see active managers turn around.

10994141.pdf (application/pdf Object)