This is part of a series on the global rise of exchange traded funds
Have we reached Peak ETF? And are we therefore at last in a “stockpicker’s market” where active fund managers skilled in bottom-up stock selection can feast on the mispricings and anomalies that the herd of exchange traded funds have left in their wake?
It is beguiling to think that this could have happened. The signs that the market has entered a new phase after seven long years of domination by loose monetary policy and low yields now seem conclusive. Miles Johnson commented in this space this week on the logical necessity that increased activity by ETFs must ultimately create more bargains to be exploited, and suggested that active managers should be cheering the rise of ETFs.
Further, the market regime change since the election has created just the conditions that active managers need if they are to outshine the index. First, correlations between stocks need to reduce. If all stocks move in the same direction, it is hard for active managers to prove their mettle. Second, dispersion of returns needs to rise. If correlations fall, but stocks scatter within a tight range, it does little to help a manager trying to beat the index after fees. A wide range of returns makes it likelier that a few well-chosen winners will carry you past the index.
This has happened. Previous correlations have broken down, and are at the bottom of their historic range for almost all the indices tracked by S&P Global. Meanwhile S&P’s SPIVA service finds that dispersion last month was its highest since May 2009, in the chaos of the rebound after the Lehman crisis. Donald Trump had set the cat among the pigeons in just the way that should help active managers.
But volatility remained very low, which should lead to an increase in idiosyncratic (as opposed to broader macroeconomic or market) risks for individual stocks. This was not chaotic, but an almost instant switch from one set of extreme market conditions to another. Deflationary stocks — high-yielders and defensive names — were out while inflationary names, such as cyclicals and financials, were suddenly in.
Sadly, the evidence so far is that active funds have not profited from this sectoral rotation. According to Barclays, 54 per cent of the US active equity mutual funds they track underperformed their benchmark in the two weeks after the election. The performance dispersion was huge, with a 4 percentage point gap between the top and bottom deciles.
More broadly, active funds have picked up a lot since the turn of the market in mid-2016, but are still lagging behind badly for the year because they positioned themselves for the late-year turnround far too early. Goldman Sachs finds that slightly more than half of US large-cap managers have beaten their benchmark since the end of June, but only 23 per cent have done so since the beginning of the year. They were far too heavily weighted in cyclicals and inflationary stocks from the year’s outset, and are still a long way behind.
This could now get awkward. Redemptions from mutual funds have already been heavy, but are seasonal, and tend to be heaviest in December as investors manage their tax liabilities at the end of the year. Further forced sales over the next three weeks would accentuate the trends in place. “Losing” stocks will be dumped, helping the losing funds lose by even more.
Why has this been such a difficult time for active funds? Because, it appears, it has been the wrong sort of, ETF-driven, dispersion. Nothing beats ETFs if you want to make a short-term sectoral bet, and so ETFs have triumphed over the past few years.
The scale of the moves in and out of sector ETFs post-election has been mind-blowing. According to Barclays’ US equity strategist Keith Parker, inflows into ETFs tracking US industrials were equivalent to 20 per cent of their market value, in just the one week after the election alone. Meanwhile, even as the market was rallying, active mutual funds continued to suffer significant outflows, and had no choice but to sell, inhibiting their ability to take advantage of the rally that the flood of ETF money was creating.
This has not, so far, been a return to sanity and careful stockpicking, but rather it has seen a lurch, all together, from one side of an overbalanced boat to the other. Even though they were well-positioned ahead of the move, many active funds seem to have been trampled on.
According to Goldman, mutual funds are now in aggregate overweight in the newly popular sectors that are receiving ETF money. If this sectoral rotation continues — which it should unless the Trump administration radically fails to put its agenda into action — then active managers might in aggregate find themselves topping the indices next year. But they will have done so by holding on to the coat-tails of ETFs and making their distortions even worse, and not by correcting them.
Any success for active managers in the near term is unlikely to herald any return to more rational price discovery. And they should not, yet, cheer the rise of ETFs.
Age of the ETF stories