15 Apr Time to Get Active?
A common refrain among financial analysts, market commentators and the general punditry these days is that during periods of market crisis and eventual recovery it’s imperative that investors are discerning with their investments. The argument is that “diversification is not your friend” and that now, more than ever, investors need to “get active” and really focus their security selection on identifying the “winners” and avoiding the “losers.” The talking heads implore investors holding broadly diversified portfolios to “ditch the indexes” and instead home in on stocks of companies that are well positioned not only to survive the current crisis but also to thrive during the eventual recovery, while conversely avoiding those with the opposite traits.
Implicit in this line of reasoning is that active managers stand to outperform indexes in the years ahead owing to their ability to skillfully identify and invest in the future outperforming companies while shunning the future underperformers. As logical as the argument seems at first glance—after all, it seems pretty apparent to us all that certain sectors and individual companies are doing better than others during the current crisis and likely stand to do better during the eventual recovery as well—I believe it deserves further scrutiny.
To test the hypothesis that active management is preferable to indexing during bear markets and their subsequent recovery, I examined the performance of equity hedge funds during the 2001-2003 and 2007-2009 equity bear markets and their subsequent recoveries vs. that of an index measuring the performance of the global stock market.
As a general rule, equity hedge funds are managed by some of the best and the brightest investors in the world. In addition to being very well resourced and highly incentivized to deliver market-beating performance (in addition to standard management fees earned for managing capital, hedge funds typically also collect performance incentive fees on profits earned in excess of a pre-determined benchmark), equity hedge fund managers typically have a full range of tools at their disposal to deliver their performance objectives. These managers further benefit from being able to profit from both the price appreciation of the overall market, individual sectors, industries or individual stocks, as well as from declining prices in these same markets, sectors, industries or individual companies. In other words, they have the ability to make money off of not only identifying and investing in the future winners but also to profit off the price declines of the future losers too. Put simply, if there’s a class of investors who ought to be able to deliver outperformance via skilled active management, it’s equity hedge funds.
My analysis evaluates the performance of a hypothetical investment in an index designed to measure the performance of equity hedge funds (HRFI Equity Hedge Total Index) to a hypothetical investment in a global stock market index (MSCI World Index) made on two different dates during each of the past two bear markets and subsequently held for five years.
The first set of charts presented below measures the performance of both indexes assuming the equal $100 investments were made at the end of the month during which global stocks first finished the month down 30% or more from their recent all-time highs. The charts reveal that equity hedge funds trailed global stocks during the hypothetical five-year investment period. The hedge funds lagged the global stock index by 8% cumulatively on investments made during the 2001-2003 bear market and by 23% cumulatively on investments made during the Global Financial Crisis. Neither episode necessarily provides a ringing endorsement for the case for active management during a market crisis.
The second set of charts presented below assumes the investments were made at the bear market’s bottom, as defined by the month which ultimately proved to be the low point of the bear market. It’s important to note that this date cannot be known in advance; rather, it can only be identified in retrospect, unlike the previous set of charts which begin with an investment date that is knowable to investors at the time (the 30% drawdown rule is knowable in real time). Nevertheless, I think it’s still a useful analysis to examine how the hedge funds performed during the subsequent recovery.
The charts above clearly demonstrate that the hedge funds dramatically underperformed the global stock index during each of the two subsequent recoveries. The hedge funds cumulatively trailed the index by 24% and 34% during the recoveries from the 2001 and 2007 bear markets, respectively.
The empirical evidence presented above strikes a significant blow to the widespread claim that active management is imperative during market crises. The data demonstrates that active equity hedge funds, on average, delivered disappointing performance relative to a global stock index for hypothetical investments made during the depths of the two equity bear markets of the 21st century. Put simply, the data compellingly makes the case that it is not necessary to investors to “get active” during a market crisis.
That said, I believe that talented hedge fund managers exist today who will deliver outperformance in the years ahead. However, the challenge for investors today—as it always has been—is that to realize the outperformance of these talented managers in the future one needs to identify those managers in advance (i.e., today) and must be willing to remain disciplined and committed to them for the long haul. A task easier said than done.
MSCI World Index performance from Dimensional Fund Advisors
HFRI Equity (Total) Index performance from Hedge Fund Research (HFR)
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An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance to certain asset classes. Index performance used throughout is intended to illustrate historical market trends and performance. Indexes are managed and do not incur investment management fees. An investor is unable to invest in an index. Their performance does not reflect the expenses associated with the management of an actual portfolio. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk including loss of principal. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market. Past performance is no guarantee of future results.
The performance of the hypothetical asset allocation portfolios was derived from the retroactive application of a model based on investments made during the first month following a bear markets bottom in global stocks and equity hedge funds. The graphs are intended to show how diversification and different asset mixes perform over time and is not intended to represent actual portfolio returns or any strategy currently or previously offered by Kathmere. The graphs are for illustrative and educational purposes only. The returns are shown gross of fees.
MSCI World Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The index consists of the following 23 developed market country indexes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
HFRI Equity Hedge (Total) Index Equity Hedge: Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.