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.