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The Rec List: picking funds in the teeth of a crisis

Welcome to The Rec List, a regular selection of the best research notes, academic papers, articles and posts on investments, compiled by Citywire's US journalists.

The Rec List: picking funds in the teeth of a crisis

Small wins

(New York) It may not be the best time to be an active fund manager, but that might make it a pretty great time to be a fund picker.

As we all know the last 10 years have not been kind to active managers, most specifically large-cap US equity investors, as the bull run and increased availability of cheap index funds have left many fund managers looking bad and expensive.

But, what about the first few months of 2020? It was a period in which the S&P 500 suffered its worst quarter since the 2008 financial crisis, falling 19.6%. Thus, in theory, it was a time for active managers to prove their worth - to show that while they lagged a raging bull, they could make up for that, to an extent, by staying ahead of a tumbling bear. So how did that work out?

Well, according to S&P Dow Jones Indices, it was a distinctly mixed bag. In a blog post titled ‘Active Managers: No Place to Hide,’ S&P’s Berlinda Liu wrote:

Of domestic equity funds, 64% underperformed the S&P Composite 1500® in the first four months of 2020… During Q1 2020, 54% of all large-cap funds underperformed; in April, the YTD underperformance percentage increased to 59%.

But, there were some bright spots among the usual doom and gloom, namely small caps, mid caps, and growth funds. Within large-cap growth, 65% of open-ended funds beat their benchmark (the S&P 500 Growth) in the first four months of 2020. Within small-cap funds of all styles, 61% beat their benchmark (S&P SmallCap 600) over this period. Within small-cap growth, 94.4% of mutual funds outperformed the S&P 600 SmallCap Growth.

As Bloomberg’s John Authers notes, some of the outperformance of small cap funds could be down the construction of the S&P index they are measured against, which has a quality bias that ‘has been a disadvantage for much of this year.’ The index’s inclusion criteria also mean it does not hold any currently popular but unprofitable biotech firms, he notes, which leaves some easy off-benchmark fun for managers to have.

Small caps aside, on the face of it the S&P report can make pretty grim reading for those involved in picking active funds (leaving aside for a minute the short time frame looked at, the fact we have no idea what part of the crisis we are really in, and that S&P has its own dog in this fight).

But, arguably, the converse is true. If every active manager outperformed over the short and / or long-term, there would be no premium in being able to separate the good from the bad. It would be as easy as day trading (joke!).

There is a reason the role of manager research exists, it’s because retail investors and many financial advisers are not great at picking funds. And, in their defence, it is not easy. So those who can identify the minority of managers who are likely to outperform (particularly over a longer time frame) are as important as ever.

You can read the S&P blog in full here.

Think differently

If you are looking for someone to guide you through a crisis, you could do a lot worse than Jeremy Grantham. The veteran value investor has an envious track record of calling bubbles and getting on the right side of major market events, such as the Japan bubble in the late 1980s, the dotcom crash of the late 1990s and the financial crisis of 2008.

In a recent podcast with portfolio manager Patrick O’Shaughnessy, Grantham calls the current crisis ‘the fourth great market event of my career,’ but also the most uncertain. Referring to the three mentioned above he says: ‘Rightly or wrongly, we took a position in the previous three, where we felt nearly certain that we were right and we presented it that way.’ But essentially, he says that things are less obvious today.

He goes to suggest that John Templeton’s famous quote about the most dangerous four words in the English language being ‘this time it’s different’ should not lead people to believe that things are never different. He argues that quite a few things are different at the moment, not least American capitalism (to how it was in 2000, let alone the 1960s) the coronavirus, and even the FAANGs. He tells O’Shaughnessy:

They [the previous three crises] were all near certainties. This one, without trying to pun, this one is novel, this is different. It is completely original. We have never had anything like this…. The five most dangerous words in the English language are ‘this time is never different.’ Because occasionally, of course, something really important happens that is different. The coronavirus is one of them.

Spoiler alert, Grantham does not tell you where to invest (although GMO’s recent allocation changes are a good indicator), but he does challenge assumptions and argues that ‘old fashioned routines have to be moderated.’

He also mentions that in calling previous bubbles he and his colleagues had been ‘painfully early,’ meaning they underperformed for a while before being proven right. Another reason, perhaps, to not be overly worried about active management’s performance so far in 2020.

You can listen the Grantham interview here and read the transcript here.

Also, you can read Citywire’s interview with Grantham from last year here. Fun fact, that interview took place at his house over cake and tea, which sounds like just about the most British thing two Brits can do when in America, but was really just a by-product of the fact he wasn’t going to the office that day. The interview touches on many of the same themes as O’Shaughnessy’s (the changing nature of capitalism, climate change, overvalued US equities etc.), but some are things are different. In early 2019 Grantham didn’t see a crisis, he does now.

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