We look at why the relative performance of active Global managers has generally deteriorated over the last decade, assess how top performing Global funds have generated their alpha, and discuss whether these trends will continue in the future.
Global active managers have had a hard time since the Global Financial Crisis, with the median fund having struggled to add value over the last decade and having failed to beat the benchmark in each of the last four years. However, this wasn’t always the case.
In fact, in the first 8 years of the century there wasn’t a single year where the median manager failed to beat the benchmark.
Median Global relative performance
Source: Evestment (gross of fees)
Something has clearly changed, and the purpose of this note is to try to analyse what exactly that is and to see if it can tell us anything about the likely patterns of performance in the future.
We split the note into three sections:
- Firstly, we take a look at the performance of regional managers to see if a similar pattern can be witnessed in every geography, or whether there are specific skews.
- We then assess structural differences between markets to see if there are underlying drivers which might explain any differences.
- Finally, we take a look at the top performing Global managers to see what it has taken to outperform over the last decade before trying to assess whether this will continue in the future.
Most Global managers benchmark against the MSCI ACWI so it is interesting to split the benchmark into its various geographic components and to look at how region-specific managers have performed.
MSCI ACWI by geography
When you do this a clear pattern emerges: while all regions have seen a step down in relative performance, GEM and European managers have been able to keep adding value over the period in question, while median Japanese managers have seemingly never added any value. The US, then, is the swing factor, having gone from modestly adding to detracting value.
Median GEM relative performance
Source: Evestment (gross of fees)
Median European relative performance
Source: Evestment (gross of fees)
Median Japanese relative performance
Source: Morningstar/Exane (net of fees)
Median US relative performance
Source: Morningstar/Exane (net of fees)
Given the importance of the US within the Global benchmark, this is likely the main driver behind deteriorating Global relative performance.
So what is going on in the US?
Explaining the US
Before diving into potential explanations, it is worth taking a step back to look at equity dispersion, or “the extent to which the returns of individual stocks within a given benchmark differ from the average return of the index”. This is important because it is commonly considered to be the “opportunity set” of the active manager - if dispersion is high, active managers should have a decent opportunity to pick the winners, but if all stocks perform in line with the benchmark, it doesn’t matter how a manager chooses to weight their portfolio, the best they can hope for is market performance.
As you can see from the chart below, equity dispersion has been on a downward trajectory since 2000, with a brief spike in 2008 before settling at a remarkably low and consistent level since then.
US dispersion vs median relative performance
Source: Morningstar/Exane(net of fees), Citigroup
Similar trends can be seen in every region of the world, but the US is notable because of its large peak-to-trough move and its decade-long low level.
The next question, then, is why? Many commentators point to the role of Quantitative Easing (QE) and ETFs to explain worsening performance. We find both answers to be helpful, but incomplete.
The impact of QE on dispersion is relatively straightforward: in a world where assets are propped up by QE, businesses which should be going bust remain afloat, flows into risk assets are relatively indiscriminate and thus the performance differential between good and bad businesses is muted. What is less straightforward is how this exerts an undue influence in the US. After all, QE is a global phenomenon, with the ECB, BoJ, PBoC and the BoE all implementing their own programmes – often expanding their balance sheets by a larger percentage of GDP and domestic market capitalisation than in the US.
Total assets of major central banks (as % of local currency nominal GDP)
Source: Haver Analytics/Yardini Research
The key to understanding the US impact lies in market structure, specifically the higher percentage of ‘long duration’/growth assets within the S&P.
are two ways of thinking about this. The
first is to take the weightings of traditional “growth” sectors as a percentage
of the benchmark. On this basis you can
see that traditional growth sectors account for a greater proportion of the
S&P than elsewhere:
The second methodology is to try to look at each market according to Macaulay duration – or sensitivity to interest rates. In fixed income parlance, duration is loosely defined as “how many years it takes for an investor to be repaid a bond’s price by the bond’s total cash flows”; the higher the duration, the more sensitive to interest rate moves. In equity markets we fall back on the short hand of index dividend yield/index capitalisation. When looked at in this way, one can see a markedly higher duration within the S&P than any other region.
Equity duration (years)
QE has loosened monetary policy on a global basis. This has caused a rush of flows into the longest duration/interest sensitive assets, which tend to be disproportionately based in the US. This in turn has depressed dispersion and accentuated market gains within the US to a greater extent than elsewhere, as can be seen below.
US market versus other regions
The other factor that is commonly cited for decreasing dispersion is the increasing prevalence of passive ETFs. The theory is that active managers will tend to buy equities according to personal preference, whereas passive funds will buy equities in line with their respective index weights. So long as flows into ETFs remain dominant, this will have a dampening effect on dispersion and a knock-on impact for active managers.
As can be seen from the chart below, there is an inverse correlation between ETF penetration and the relative performance of active managers.
ETF penetration versus relative performance
While such inverse correlation is clear, we think there are a few nuances worth elaborating on to fully understand what is going on.
The first is that ETFs are not a standalone explanatory variable. They have a symbiotic relationship with QE and thus should be viewed partially as a symptom as opposed to the disease per se.
The second nuance is that there are a variety of additional structural factors that make the US more vulnerable to ETF penetration than elsewhere. Examples include the US’s superior liquidity compared to Emerging Markets and the prevalence of bank-led asset managers across Europe, given that they tend to act as investment gatekeepers and are more likely to funnel their clients’ assets into higher margin active products.
The final point to make about ETFs is perhaps the most overlooked; not all ETFs are simple index trackers – they come in a variety of different shapes and sizes. Like any other industry, ETFs have a tendency to cater to the hot topic du jour. Artificial Intelligence, Cannabis and Vegan ETFs all spring to mind. The unintended consequence of this is a tendency towards overlapping positions in things that have worked, which further distorts markets. As an example of this, take a look at the holdings of a Vegan ETF below:
Source: Beyond Investing
It is essentially a list of long duration Tech stocks packaged within a trendy thematic.
Unsurprisingly, many of the more fashionable growth stocks within the S&P have far higher ETF ownership levels than the market overall, which is because they are not only held within S&P trackers, but also within Tech ETFs, Vegan ETFs, Growth ETFs etc.
ETF ownership (%)
Source: Lipper, Bloomberg
So as long as flows into ETFs continue to be a dominant market feature, they will serve not only to depress dispersion at an aggregate level, but also to crowd market leadership into ever fewer names. Such narrowing market leadership can be seen below.
US equity ETFs
% of S&P500 constituents outperforming S&P500 over L12M
Despite all of these headwinds, there are still Global managers who have been able to achieve strong outperformance in recent years, so how have they done it?
The chart below shows all Global managers that have been able to outperform the benchmark by an annualised 3% over the last 3 years (dark green). This is overlaid with bottom quartile funds (light green):
Top performers versus bottom quartile (P/E)
What is very clear is that the higher the average P/E of a fund, the higher the outperformance. This is unsurprising, of course, in the context of the growth discussion, but stark nevertheless. In fact, the average “top performing” fund has a P/E premium of approximately 30% versus the market (22.3x vs 17.4x).
A similar dynamic can be seen regardless of which valuation metric you choose to look at. For example, on a price to sales metric, the average “top performing” fund has a premium of approximately 90% versus the market (3.25x vs 1.7x):
Top performers versus bottom quartile (P/S)
Similarly, on a price to book metric, the average “top performing” fund has a premium of approximately 100% versus the market (5x vs 2.5x):
Top performers versus bottom quartile (P/B)
There are undoubtedly a variety of idiosyncratic reasons for the performance of each of these funds, but without wanting to oversimplify the issue, it seems reasonably clear that in order to materially outperform in such an extreme world, managers have had to run increasingly extreme portfolios – heavily skewed towards expensive growth stocks.
The optimal strategy in recent years has been to buy quality/growth at any price. Any consideration of valuation has served, if anything, as a net detractor of performance.
Where to from here?
Throughout this note we have tried to show how a variety of factors have coalesced to dampen alpha generation for Global managers. To recap:
- QE has limited the opportunity set across the board
- This has hit the US (the largest part of the Global benchmark) disproportionately because of the prevalence of long duration growth stocks there
- When coupled with active underperformance, this has driven ETF penetration, exacerbating the dispersion problem and crowding investors into a small number of stocks due to overlapping holdings
What is important to bear in mind is that each of these factors build on each other in a leveraged unvirtuous cycle such that when you step back and take a look at the market in aggregate, many of its features appear extreme.
Growth vs Value – Global
Or the percentage of the US market made up by the five largest stocks:
% of US market made up of 5 largest stocks
Or even the absolute multiple of the S&P:
S&P 12m forward P/E
With regard to the chart above, it is important to note that the extremely high earnings multiples witnessed in the late 90s/early 2000s were driven by a raft of new tech companies with no earnings and thus the “E” component of the P/E metric was highly skewed at an index level. As a means of adjusting for that, index level price/sales multiples perhaps give a better sense of how current valuations compare to history:
SPX price to sales ratio
Of particular concern to us is the size and role of ETFs at present. At their core these are very simple creatures. They do not play a role in capital allocation between stocks, or take a view on valuation. An investor does not hold an ETF because they trust the manager, or have any detailed understanding of the underlying assets – they hold it for a very simple reason: because they have a positive view on market direction.
When times are good this strategy makes complete sense. It is low cost, with no cash drag and a very high probability of fully participating in the upside of the market. When times are tough, however, that very simple decision process can turn on a sixpence.
Given the relative immaturity of the ETF industry, this is not a theory that has been tested to any material extent. It has been 12 years since we have had a period of substantial volatility, and back then ETFs only accounted for around 5% of the S&P. Nowadays this number is closer to 20%. That is 20% of the market (disproportionately crowded into a small number of names) which is likely to sell as soon as “the market always goes up” ceases to be the prevailing mantra.
Were that to happen, then the whole process described throughout this paper would reverse; popular growth names would experience disproportionate selling and dispersion would rise.
With the market already stretched to such extremes across many of the metrics shown above, is now really the time to own ultra-long duration growth portfolios at a 30-100% valuation premium to an already expensive market?
TT Global Equity Strategy
Our Global Equity Strategy invests for the long term. Given that you never know what tomorrow may bring, this naturally skews us towards high-quality companies capable of generating double-digit returns on invested capital, even at the bottom of the economic cycle. Importantly, though, we also have a valuation overlay. The table below shows that our portfolio offers superior quality at similar valuations to the wider market.
We are not a value fund, but refuse to pay any price for an asset. While this means that in recent years we have not been shooting the lights out like a small handful of ‘quality at any price’ managers, we have still been able to generate strong risk-adjusted returns. Crucially, we have done so without adopting a significant growth bias, and whilst running a beta of 0.9 or below throughout the period.
At this point of the economic cycle, with the internals of the market as extreme as they currently are, we believe that this is a sensible approach. In our view, investors who have benefited in recent years from valuation agnostic markets should seek to dial back their growth risk and consider funds such as TT’s Global Equity Strategy to help them meet their investment goals in the next stage of global markets.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT International Asset Management Ltd is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).