Oh, poor fund managers. Why the long faces?
July was great! The S&P 500 had its best performance since late 2020, rallying 9%. It was one of the best months in the market of all time. Of course, the withdrawal of generosity from the world’s major central banks introduces a new wave of volatility in asset prices, but this has to be the rally we’ve all been waiting for, right?
Apparently not. Instead, it seems to be another pain trade. Bank of America notes that despite last month’s super rally, only 28 percent of active fund managers focused on large stocks outperformed their Russell 1000 benchmarks. All major mutual fund styles had a Underperformance: Basic, Growth and Value.
Kudos to the minority, but how did everyone else do? All year long, investors have been desperate for a break in the clouds and finally the hint of some leniency from the Fed is coming, and they are still lagging their benchmarks. It seems that too much money was tied up in the safe cash stash and too little was deployed upwards.
A bearish stance “likely weighed on performance,” BofA analyst Savita Subramanian and colleagues said in a note to clients. Opportunities to beat the market are still few and far between, he added, making this a “difficult environment” for funds that pick stocks rather than indexes.
One explanation for this is that professional investors are not stupid. This hint of leniency from the world’s most powerful central bank was vastly over-interpreted and had many more caveats than the market’s initial reaction suggested.
All Fed Chairman Jay Powell said was that it would probably, but not definitely, be appropriate to slow the pace of interest rate hikes going forward. Some market participants took that as a cue to increase bets on rate cuts and return to stocks that have suffered as the Fed has talked tough on inflation. This week, a series of Fed speakers told markets to calm the devil down. They are still nowhere near a pivot and expectations of rate cuts next year are premature, they said.
Another way to think about it is to ask who was doing the shopping. A good portion of this appears to come from extremely bearish funds, with many shorts (or bets against stocks) on their books. Hedge funds and momentum chasers like commodity trading advisors (CTAs) had pulled well out of risky assets and then struggled to catch up when stocks rallied, a known practice as a short hedge.
“The equity rebound . . . in July was primarily due to short covering,” wrote analysts at Barclays. “Shorter stocks have outperformed in Europe and the US.”
An equally weighted basket of the 50 shortest stocks in the Russell 3000, “led by the most speculative . . . not-for-profit names,” is up 31 percent since June, says Neil Campling, an equity analyst at Mirabaud. with Europe catching up.
Anik Sen, head of equities at PineBridge Investments, is what you might call a bottom-up investor, building portfolios focused on a relatively small number of stocks: 30 to 40. His mission is to pick good stocks and neutralize the effect of wider index movements. This task, he says, is increasingly complicated by the outsized role played by equity flows from macro funds and CTAs.
“He’s been doing this for over 35 years, almost 40 years. The disconnect between bottom-up and top-down is possibly the widest I’ve seen,” he says. “Markets are not moved by you and me, but by macro traders. . .[Their flows]eclipse those of fundamental investors.”
This cuts both ways. Sen’s view is that the July rally is “sustainable” and that markets have been too gloomy for much of this year. Some corporate stories are much stronger than investors give them credit for, he believes. “We can’t understand why the markets are so negative,” he says, adding that the war in Ukraine, inflation, supply chain tensions and the Covid shutdowns in China have masked positive factors.
But the poor performance of mutual funds in July highlights how broad changes in asset allocation pinned on powerful macroeconomic trends are specialists in railroad stocks.
My sense from talking to fund managers is that this is becoming extremely frustrating. They were wrong to be so positive at the beginning of the year and then they lost a trick in July. The best approach now is probably to be a little philosophical.
“You can easily get caught up in short-term moves,” said Mamdouh Medhat, senior researcher at Dimensional Fund Advisors, the quant house founded in the 1980s. .
As boring as it sounds, sticking with the markets for the long term is still almost always the best tactic. “It’s very, very difficult to beat the market by trying to guess it. People will make the right calls sometimes by sheer luck,” Medhat says in the soothing tone of a therapist. “Be stoic. . . . If you’re broadly diversified, you’re getting the only free lunch in finance,” he says.