For many, a can of sardines conjures up an image of the Depression-era 1930s where the slippery little fish were an easy and cheap inexpensive source of protein for the masses. Likewise, in their natural environment, sardines are also viewed as an abundant and easy source of protein for their natural predators. But in the sea, they are much more elusive than in a tightly packed can of oil! Upon being threatened, the sardines’ defense is to school tightly in a ball with each tiny fish swimming in the same direction as all of the others, making it impossible for the far faster and stronger tuna, marlin, and dolphins to target a particular fish.1 This dance between the shimmering silver “meatball” and its midnight and cobalt attackers is a stunning visual image and a remarkably effective defense for the seemingly outgunned sardines.
During 2011, securities in most markets behaved remarkably like resilient sardines. Risk on and risk off, largely due to the European sovereign debt crisis and central bank intervention, led to securities moving very much in line and offering tightly clustered returns. With little cross-sectional mean reversion and a value headwind, this environment proved to be a tough market for active managers and a mixed one for the Fundamental Index™ approach.
When Security Mispricing is Good…
Active management and the Fundamental Index approach both rely on the existence of mispricing of securities and their eventual correction to add value relative to the cap-weighted benchmark. The active manager that initiates a long position in a stock does so presumably because its research indicates the stock is undervalued and will appreciate faster than the broad market.2 Of course, this appreciation can happen only when other active participants also become aware of the mispricing and move to capitalize on it, thereby pushing the security’s price closer to “fair value.” This process is critical to the success of active managers.
The path to excess returns for the Fundamental Index strategy is different. If market prices drift away from fair value, then a capitalization-weighted index will structurally overweight overpriced stocks and underweight underpriced stocks, leading to a return drag. Agnostic about which securities are actually mispriced, the Fundamental Index methodology simply uses non-price measures of company size to randomize the link between portfolio weight and mispricing—thereby creating a portfolio, sans return drag, capable of achieving excess returns while simultaneously preserving the many attractive attributes of passive investing.
Given that both active management and the Fundamental Index approach require corrections to security mispricing to generate excess returns, these strategies do not work in periods when those corrections are not occurring. When all (most) stocks move in the same direction, the amount of relative price movement expected at the individual security level will be minimal, and the ability of the strategies to capitalize on mispricing will be modest at best. Sadly, 2011 was just such a period.
End Market Correlation!
One of my favorite e-mails this year was sent by a friend during the height of the “Occupy Wall Street” movement. Rather than the typical rally cry of “End Market Corruption,” a well-dressed investment manager in the photo holds up a sign that reads “End Market Correlation.” Individual stocks moved substantially in tandem in 2011. In a recent note, Jim Bianco, president of fixed-income analyst Bianco Research, observed that from 1996–2008, there were only 12 days (2 up and 10 down.) when more than 490 of the S&P 500 Index moved in the same direction on a given trading day. In 2011 alone, we had 15 such days (with a nearly even up/down ratio). The markets went back and forth on big move after big move—all with little price differentiation.
According to the Leuthold Group, the average correlation among S&P 500 stocks reached a peak in early October (86% on 50-day price movement) that exceeded the previous peak on Black Monday in October 1987 (82%).3 Bianco explained: “… the actions of people like Ben Bernanke or Mario Draghi matter far more than any specific fundamental of a company. It’s as if every S&P 500 company has the same chairman of the board that only knows one strategy, resulting in a high degree of correlation between seemingly unrelated companies.”4
Worst Year Ever for Active Managers?
Such a lack of differentiation proved to be a difficult environment for stockpickers. In early 2009, we published an article called “2008—The Worst Year Ever for Active Management”5 where we analyzed how active managers fared in six widely used asset classes and styles over a nearly 30-year span. In Table 1, we replicate those results and add the relative performance of managers in 2011. Like the crisis year of 2008, last year we witnessed poor returns from active management, especially in large developed equity mandates. Large-cap core, large-cap growth, and developed ex U.S. (“international”) all posted relative results that ranked in the bottom four of the past 22 years. On a diversified portfolio level, these uninspiring results led to the third-worst year relative to a passive cap-weighted implementation.
The magnitude of the active manager underperformance wasn’t as bad in 2011, but the breadth was worse as the median manager in five of the six asset classes failed to beat their benchmarks. The only other year where this happened was 1998, also a crisis year as a Russian default led to Long-Term Capital Management nearly bringing Wall Street to its knees. Only the median U.S. small-cap manager was able to escape with a win in 2011. Everywhere else, be it value or growth, U.S. or non-U.S., the median manager trailed its cap-weighted benchmark. And these figures are before management fees!! Obviously, the near unanimous ups and downs of the market in 2011 failed to produce the kinds of security selection opportunities that have come to benefit active management.
The Fundamental Index Strategy in 2011
Against such a backdrop, the Fundamental Index methodology produced mixed results. The FTSE RAFI® All World 3000 posted a return of –9.1% versus the MSCI All Country World Index’s loss of –6.9%, a shortfall of 2.2%. Likewise, the FTSE RAFI® US 1000’s small gain of 0.1% trailed the S&P 500 by 2.0%. Given these fundamentally weighted strategies have historical tracking errors to comparable cap-weighted indexes of 4–5%, such underperformance is well within the expected range of relative returns for a one-year period. Indeed, even after incorporating the 2011 shortfall, both the FTSE RAFI All World 3000 and FTSE RAFI US 1000 have positive excess returns since inception over the respective cap-weighted indexes of 1.4% and 1.7%, in markets that haven’t been kind to value.6
The high correlation of securities returns that hurt active managers was impaired by the Fundamental Index strategy performance. As we have stated previously, the Fundamental Index methodology is a rebalancing and contra-trading strategy.7 However, this approach proved to be futile last year. Using sectors as an example, Figure 1 outlines the seven S&P 500 sectors that had double-digit weights in the index as of year-end 2011 and their relative returns to the S&P 500 in 2010 and 2011. Sizeable excess returns in the Fundamental Index strategies come from contra-trading into recent laggards before they take off (think consumer discretionary and financials in 2009), or out of recent winners before they fall off a cliff (tech and telecom in 2000). In the major sectors in 2011, such reversion was sadly lacking. Only health care, a perennially underweighted RAFI bet due principally to high-priced biotech stocks, experienced a double-digit swing of excess returns. The consumer discretionary, energy, and financials sectors were dominated by momentum as they repeated their prior year outperformance (consumer discretionary and energy) or underperformance (financials). In the sectors that did reverse 2010 performance (consumer staples, industrials, and IT), the differentials were hardly large enough to earn anything more than trivial contra-trading profits.
Last year, we launched our second major Fundamental Index family—the Russell Fundamental Index® Series. Russell uses their own set of economic factors to weight securities—adjusted sales, retained cash flow, and dividends plus buybacks. As we’ve stated repeatedly, there’s no magical set of fundamental size factors. All should produce similar excess returns over long periods of time; the key is to break the link with price in the selection and weighting process. Over shorter periods of time, different financial metrics can and will produce different return patterns. We saw just such a divergence in 2011. The Russell Fundamental Global return of –6.5% actually exceeded the MSCI ACWI by 40 basis points. Similarly, the Russell Fundamental U.S. Large Company outperformed the S&P 500 by 80 basis points for the calendar year. While both indices outperformed their cap-weighted benchmarks in 2011, the incremental positive returns fell short of longer term results. The bottom line: in 2011, the Fundamental Index approach fell short of its long-term promise, given last year’s highly correlated markets.
The remarkable protection provided by the schooling sardines nearly always comes to an end. The predators pick up numbers and begin to work together, methodically circling the shimmering mass and driving it in a slow upward ascent. Sure enough the sardines reach the ocean’s surface, and can no longer swim as one. With birds attacking from the air and marauding tuna, marlin, and dolphin torpedoing from below, the sardines are forced to scatter in small packs where they are savagely picked off until seemingly the entire ocean gets its fill.
Likewise, the policy-driven and highly correlated equity markets so unkind to excess return seekers will break rank—perhaps very soon. The day of reckoning will likely come for Greece sometime in the first half of 2012. Such a default will almost certainly cause volatility and price dislocation, perhaps even hitting the value sectors currently emphasized in some Fundamental Index approaches. However, as 2008 and 2009 illustrated, failures of a few can have dramatic impact on the survivors’ ability to deliver handsome profits and excess returns.
Forget about a small can full of sardines, contra-traders have a bigger appetite. See you at the surface.
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1. Tuna and marlin have been clocked at speeds of over 40 mph.
2. Likewise, a long/short manager shorts an overpriced stock in anticipation that it will underperform the market once others also realize and correct for the overpricing.
3. Bianco Research, LLC.
4. Bianco Research, LLC.
5. See "2008—The Worst Year Ever for Active Management," RAFI Fundamentals, March 2009.
6. The FTSE RAFI All World 3000 was launched October 6, 2008, while the FTSE RAFI US 1000 was launched November 28, 2005.
7. See “The Great Contra-Trade,” RAFI Fundamentals, May 2009.