The market rally offers tough lessons for fund managers

Oh, poor fund managers. Why the long faces?

July was great! The S&P 500 has had its best performance since late 2020, with a 9% rally. It was one of the best months on the market of all time. Sure, the withdrawal of generosity from the world’s top central banks introduces a new wave of volatility in asset prices, but this has to be the rebound we’ve all been waiting for, right?

Apparently not. Instead, this appears to be yet another exchange of pain. Bank of America notes that despite last month’s super high, only 28% of active fund managers focusing on large stocks beat their Russell 1000 benchmarks. All major mutual fund styles underperformed: core , growth and value.

Kudos to the minority, but how did everyone else manage this? Throughout the year, investors have been desperate for a break in the clouds, and finally comes the hint of some leniency from the Fed, and they are still lagging behind their benchmarks. It appears that too much money has been locked in the safe-deposit box of cash and too little has been used in the recovery.

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 slim, she added, making this a “tough environment” for funds that choose stocks rather than ride indices.

One explanation for this is that professional investors are not foolish. That hint of leniency from the world’s most powerful central bank has been largely over-interpreted and has resulted in far more warnings than the initial market reaction suggested.

All Fed Chairman Jay Powell has said is that it would probably, but not definitively, be appropriate to slow the pace of interest rate hikes going forward. Some market participants took it as a cue to raise bets on rate cuts and return to stocks that suffered as the Fed spoke harshly about inflation. This week, a number of Fed speakers told the markets to calm the devil. They are not yet close to a pivot and expectations for rate cuts next year are premature, they said.

Column chart of the S&P 500 index, showing the monthly percentage change Can the US equity rally continue after the best month since 2020?

Another way to think about this is to ask who was making the purchase. A good portion appear to come from extremely bearish funds, with many shorts – or stock bets – on their books. Hedge funds and momentum trackers such as commodity trading advisors – CTAs – had pulled out of risky assets well and then scrambled to recover when stocks rose, a practice known as short hedging.

“The rebound of equity. . . in July it was mainly due to short hedging, ”Barclays analysts wrote. “The shorter stocks have actually outperformed in Europe and the US.”

An evenly weighted basket of the 50 shortest stocks in the Russell 3000, “led by the most speculative. . . nonprofit names, “has risen about 31% since June, says Neil Campling, an equity analyst at Mirabaud, with Europe now catching up.

Anik Sen, head of equities at PineBridge Investments, is what you would call a bottom-up investor, who builds portfolios focusing on a relatively small number of stocks, from 30 to 40. His mission is to pick the good stocks and neutralize the effect. of larger movements in the indices. That task, he says, is increasingly complicated by the oversized role played by equity flows from macro funds and CTAs.

“I have been doing this for more than 35 years, almost 40 years. The disconnect between bottom-up and top-down is perhaps the largest I’ve ever seen, ”she says. “The markets are not moved by you and me but by macro traders. . .[Their flows]they undermine those of fundamental investors ”.

This cuts both ways. Sen’s view is that the July rally is “sustainable” and that the markets have been overly gloomy for much of this year. According to him, some corporate stories are much stronger than investors credit them. “We can’t understand why the markets are so bad,” he says, adding that the war in Ukraine, inflation, supply chain tensions and closures due to Covid in China have masked otherwise positive factors.

But the weak performance of mutual funds in July underscores how large asset allocation shifts linked to powerful macro trends are rail equities specialists.

My feeling from talking to fund managers is that this is getting extremely frustrating. They were wrong to be so positive at the beginning of the year and then they missed a shot in July. The best approach now is probably to be somewhat philosophical.

“You can easily get involved in short-term movements,” said Mamdouh Medhat, senior researcher at Dimensional Fund Advisors, the quantitation house founded in the 1980s. “It’s like a game of ping-pong and commenting on every hit of the ball.”

As boring as it may sound, staying in the long-term markets is still almost always the best tactic. “It is very, very difficult to beat the market by trying to outdo it. Sometimes people make the right calls out of sheer luck, “Medhat says in the calming tone of a therapist.” Be stoic … If you’re widely diversified, you’re getting the only free lunch in finance, “he says.

katie.martin@ft.com

Leave a Reply

%d bloggers like this: