The market period from 2006-2010 was extremely difficult for many active long-only (and long/short) equity managers, which found their ability to produce alpha acutely challenged, particularly if their investment decisions are based on the intrinsic fundamental characteristics of individual stocks. Heightened macro uncertainty and correlations over this period, as well as increased use of index trading products, replaced stock fundamentals as the driving determinants for securities price changes.
As a manager of entrepreneurial managers, FIS Group conducted extensive due diligence on investment management firms with less than $2 billion under management, to identify the best performers. The majority of these small emerging managers employ an active, fundamentally driven investment approach.
FIS Group conducted research on the major factors driving the alpha impairment in an overall environment of extreme macro uncertainty caused by the global financial crisis and fiscal interventions implemented by the G20 governments to remedy it. The research produced two factors that had the highest impact on active investment strategies: (1) extreme market volatility; and (2) unprecedented market correlation.
Uncertainty of course has a causal relationship with market volatility. The “once in a lifetime” events of 2008-2010 (the bursting of the credit bubble, TARP, bank bailouts and quantitative easing, European debt crises, “flash crash” and QE2) saw volatility — measured by the standard deviation on the S&P 500 index — rise to 206.12 from 2006-2010 vs. 125.89 from 2001-2005. High volatility also increased demand for instruments that allow investors to trade the whole market. ETFs traded and stock futures volume increased 6000% and 52% respectively, from Dec. 31, 2005, to the end of 2010. This period saw sector and market cap correlations more than double, compared to 2001-2005.
We examined whether the performance advantage of entrepreneurial managers over their established manager peers (by investment style and market capitalization) observed in our and other prior research had altered as a result of the changing macroeconomic and market environments. Our manager universe data came from eVestment and FIS Group's online manager database, which tracks more than 900 small-manager products.
We analyzed return data for these managers for five major (by assets held) long-only equity categories: Large Cap Core, Large Cap Value, Large Cap Growth, Small Cap and Global (non-U.S.). Our research showed that entrepreneurial managers produced more excess return per unit of tracking error for four of these equity categories: Large Value, Large Growth, Small Cap and Global Ex-U.S. Equity. Established managers had the edge in only one category: Large Core. However, even for that category, entrepreneurial managers actually outperformed the Russell 1000 index.
Even though most entrepreneurial managers offer active management strategies with relatively high tracking error, entrepreneurial managers still outperformed their established manager peers over the five years ending Dec. 31, 2010, without incurring appreciably more risk. We believe this is because entrepreneurial managers exhibited more concentrated, higher conviction portfolios with higher tracking error than their established manager peers.
Another key structural performance advantage appeared to be derived from entrepreneurial managers' greater flexibility to invest in less liquid and higher returning market segments. The combination of large asset pools with commonly used guidelines that limit a manager's exposure to a maximum percentage of the outstanding shares of listed companies likely constrained established managers' ability to take advantage of the higher returns generated by smaller and less liquid stocks. To access these less liquid market segments and stay within such position limits, established managers would have had to increase their number of holdings. This is likely why our analysis over the years shows that established managers hold substantially more securities than entrepreneurial managers. However, the downside of this approach is that the established manager's portfolio would begin to become more index-like, thereby diluting stock specific alpha.
As the economy improves, increased macro certainty should continue to normalize correlation relations which would in turn be expected to be more hospitable for active management strategies going forward. However, structural changes and the growth of index-based trading instruments have likely raised the level of correlations beyond the normative levels that existed prior to 2006. Therefore, managers may want to consider monitoring changing relationships in correlations and volatility on the efficacy of their investment processes. In addition, in a world in which business strategies, trade flows and monetary policy have become increasingly interconnected, managers would be well advised to more systematically evaluate the potential impact of significant macro policy risks and actions (at least among the G20 block of countries) on the fundamental factors evaluated in their current strategies.
Tina Byles Williams is CEO and chief investment officer of FIS Group Inc.