Academics have studied various precise definitions to see whether stock-picking stock mutual funds beat their benchmarks more in certain types of markets than in others. This work has not resulted in a firm consensus, but there is marginal statistical evidence that high individual stock volatility, low index volatility, low pairwise correlations between individual stocks, and high dispersion of stock returns stocks help active managers versus benchmarks.
If this is correct, we had a pretty good stock picker market from late 2016 to September 30, 2020, but things have changed. It is often said that the opposite of a stock picker market is a quantitative stock market. When stock prices deviate from long-term historical relationships, pickers thrive, but when fundamentals drive the markets, quants are king. At least that’s the theory.
Actively managed US equity mutual funds have underperformed their benchmarks by an annualized average of 2.3% since September 30, 2020, compared to 0.7% for the period from December 31, 2016 to September 30, 2020. The latter figure is roughly the average expense ratio for these funds. Over the long term, actively managed equity mutual funds tend to underperform their benchmarks by little more than their expense ratio, so 2016 to 2020 was a better than average period. but hardly anything to celebrate as a stock-picking market. As of September 30, 2020, however, this seems to be a stock picker’s nightmare.
But maybe good stock pickers work for hedge funds, not public mutual funds. From December 31, 1999 to December 31, 2016, long-short equity hedge funds (stock-picking funds) had annualized excess returns of 7.3% per year. These returns are not as reliable as public mutual fund returns for many reasons, and experience suggests that average hedge fund investors generally do slightly worse than published indexes. Yet we can look at relative numbers. From Dec. 21, 2016, to Sept. 30, 2020, long-short equity hedge funds posted an average annualized return of 8.2%, twice as much as the previous 17 years, enough to qualify the market period of pickers as securities. But their annualized excess return since Sept. 30, 2020 has been even better, 8.5%, so we may still be in good stock picking territory.
Long-short equity hedge funds focus on individual stocks, global macro hedge funds focus on broad economic drivers. You might expect the global macro economy to thrive in the opposite type of market, favorable to long-short stocks. If all stocks rise and fall together in response to macro news like inflation and currency regimes, you would expect aggregate analysts to offer more value than individual stock researchers. Global macro hedge funds generated an annualized surplus of 7.2% from 2000 to 2016, 4.6% from 2016 to September 2020 and 7.6% since then. So the so-called stock picker market hurt the returns of macro funds, but the end of that market simply brought them back to their historical average performance.
The beneficiaries of the regime change in September 2020 were quantitative funds. The table shows the performance of five Fama-French factors. These are simple investment rules used as standards in university funding. The “size” factor, for example, is the total return of a portfolio that buys the smallest 30% of stocks and shorts the largest 30% of stocks, rebalancing once a year at the end of June.(2) The value portfolio similarly buys the 30% of stocks with the highest book-to-price ratios once a year and shorts the 30% of stocks with the highest book-to-price ratio. lowest price.
The period from 2017 to September 2020, known as the “quantum winter”, was the worst for the factors as far back as they were calculated – 1963. Value was killed, size and caution had terrible yields, and hardiness only gave anemic results. Only momentum worked well. Things reversed in September 2020, with the first four factors offering exceptional returns and a loss of momentum.
Fama-French’s factor portfolios are not intended to be held as standalone investments, but to be added to an equity index fund. A portfolio comprised of an equity index plus 20% of each of the factors outperformed the market by 4.8% from 2000 to 2016, but reversed that trend to underperform by 4.7% from 2016 to September 2020. It has since returned to 15.3% outperformance.(1)
Quantitative mutual funds and hedge funds use much more sophisticated factor strategies, as well as some non-factor strategies. Nevertheless, it is generally true that when Fama-French factors are doing well, quant is booming, and when Fama-French factors are running out of steam, quant is in trouble.
While past performance is not indicative of future results, market regimes seem to persist in the medium term. When it comes to public mutual funds, now is a bad time to pick stocks, but long-short equity hedge funds seem to be doing well. Macro funds had a poor period from 2016 to September 2020, and quantitative funds had a terrible time. The global macro is back to the historical average, the quantitative funds seem to be having an exceptional run.
Although I don’t have a crystal ball, macroeconomic factors such as inflation, Federal Reserve stocks, midterm elections, Ukraine, energy, the euro, and China seem likely to boost markets for at least the remainder of 2022. Now seems like a good time to me to try to be on the safe side of global economic forces rather than getting into the weeds of individual stock prospects.
• If this is your first bear market, don’t panic: Nir Kaissar
• Think risk factors rather than asset classes: Mohamed El-Erian
• Bond traders are as confused as everyone else: Robert Burgess
(1) I’ve oversimplified, the actual construction is a bit more complicated, but that’s the general idea.
(2) You can loosely think of this as a portfolio that doubles stocks in the top 30% of the five quantitative factors, holds no stocks in the bottom 30% of the five quantitative factors, and has intermediate weightings of stocks with mixed quantitative signals.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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