Charting the Market: A Boom/Bust Year for Active Management

Following the systematic selloff at the onset of the pandemic, coordinated central bank efforts, including quantitative easing (QE) and purchase programs aimed at supporting market liquidity, played a major role in stabilizing and improving the overall risk appetite. However, it wasn’t until the world received positive vaccine development news that the foundations of support laid by policymakers – like a bridge loan to an entrepreneur before they are pre-revenue – that a broad-based market rally started.

Despite the strong returns for risk assets, volatility remains elevated as the CBOE VIX Index registered 218 consecutive days above 20 to close out the year.¹ With these erratic movements featuring big up and down days, to say 2020 was challenging would be an understatement. And the trends in active management performance reflect the boom/bust nature of last year.

To help inform investors’ decisions on where to be active in a portfolio, this charting the market highlights the full-year performance figures for active managers across a variety of strategies.

Equity: Hit and miss rates
For this analysis, we broke up the Morningstar universe by the traditional nine-box and overseas categories, calculating the percent of managers in each bucket that outperformed their respective prospectus benchmark (hit rate). This allows for more specific takeaways on which type of active manager did well, or poorly, in 2020. As shown below, only three market segments in US-focused strategies had a hit rate above 50%. As a result, I think it’s fair to conclude that most US active managers had a tough year in 2020.

This notion is furthered by comparing 2020 performance with 2019. Just four segments had a higher hit rate in 2020 than they did in 2019 – despite the elevated volatility and dispersion that typically create a more conducive environment for active stock selection than when dispersion is depressed and stock movements are not differentiated. Yet, until recently, breadth was poor and correlations converged, so not all vitals were conducive.

Growth managers, irrespective of market cap focus, had the strongest hit rates in 2020, underscoring how growth drove the market. However, the tide did shift in the fourth quarter following positive vaccine news that sparked a reflation rally. Both large- and mid-cap value managers had the strongest hit rates over the last three months of the year. The same effect was evident overseas, with foreign value managers staging a bit of a comeback in the fourth quarter (56% hit rate).

Yet, growth won out overall in 2020. Counter to the performance trends in broad US funds, emerging market managers and foreign fared better overall – both posted hit rates over 50% alongside positive average excess returns (2.93% and 1.41%, respectively).²

Oddly, both the full-year growth performance and the value boost in the fourth quarter run counter to the index purity theory³ – a premise that essentially states that when the value style is in favor, growth managers should do well versus their benchmark as a result of having some form of style drift (e.g. some value exposure) and vice versa. Now, the purer a value exposure was the stronger the performance, evidenced by the S&P 500 Pure Value Index outperforming the S&P 500 Value Index by 11.40% in the fourth quarter.⁴   Looking ahead, if the value rally holds and the trends from the fourth quarter persist for active managers, this could lead to a renaissance for value managers versus the traditional value benchmarks that are not as “valuey,” given their naive construction and cap weighting process.

Fixed Income: Hit and miss rates
If 2020 was a rollercoaster, then the first quarter featured active managers closing their eyes as the big drop occurred. In the first quarter, as shown below, only 12% and 6% of intermediate core and intermediate core-plus mangers beat their respective benchmarks. Yet, much like how the market staged a rally, so did these managers. In the subsequent three quarters, the lowest hit rate witnessed was 77% and 83% for intermediate core and intermediate core-plus mangers, respectively.

These performance trends are a likely byproduct of active managers taking on elevated credit risk, a notion underscored by the fact that, historically, the average fund’s excess return within the intermediate core-plus relative to the Agg has a 95% correlation to high-yield bonds’ excess return to the Agg, based on rolling one-year periods.⁵ This appears to have held true once again in 2020, as high yield underperformed the Agg by 16% in the first quarter, then outperformed by 7%, 4%, and 6% in the following three quarters.⁶ And as shown below, the average manager excess return versus the prospectus benchmarks for those managers follows a similar trajectory.

Despite this strong performance from high yield as an asset class, active managers within high yield had a hard time beating the benchmark and witnessed the same success as core managers, as shown above. In fact, the performance in 2020 was worse than in 2019.

Jumping over the bar, but by how much
The excess return figures for US equity managers provide further insight into the trends from 2020. As shown below, the majority of active growth managers just didn’t beat their benchmark – they trounced it. The rationale for this is likely found in some of the exponential returns from high growth/innovative stocks at the forefront of the disruptive technologies reshaping our society – an aspect reinforced by how mid and small-cap growth managers had the largest full-year excess returns because innovation tends to happen further down the cap spectrum.

Not surprisingly, given the earlier hit rate numbers, the excess return figures for full-year 2020 for all other categories are quite poor – and are the worst within mid-cap. One beneath the radar trend that becomes more apparent when examining the performance in the fourth quarter by both the hit rate and excess return analysis is the weak performance of small-cap managers. Given the torrid rally for the small-cap index where the S&P 600 Index rallied by 31% (its best quarterly return ever)⁷, it may have just been too hard to keep up – despite breadth improving as the equal-weight version of the S&P 600 outpaced the cap-weighted version by 4%.⁸

Weak Figures Propel Strong Growth in Index
For US equity strategies, specifically, these performance trends are not one offs. Similar patterns of underperformance have emerged when analyzing the average percent of funds that underperformed their prospectus benchmark, and their magnitude of underperformance, based on rolling one-year windows (monthly granularity) over the past 10 years.⁹ Based on this approach, only 35% of US large-cap managers outperformed in twelve month periods over the past 10 years.¹⁰ More analysis can be found here in our portfolio construction for the next decade article.

The derivative of this is the exodus from active mandates. And with $500 billion going into ETFs in 2020 and over $300 billion being redeemed from mutual funds, ETFs have now firmly taken in more assets over the past 20 years than mutual funds -- $3.6 trillion to $2.5 trillion, as shown below. The fervent migration of assets out of mutual funds and into ETFs is not new. We witnessed this trend during and after past market events (e.g., 2008/2009) – and I’d expect this interest in ETFs to continue following the COVID-19 crisis and the uneven high-fee active manager results.

Allocating in a Boom/Bust World
Even in the midst of a hopeful recovery, idiosyncratic risks remain high in 2021 as a new administration enters the White House and an inconsistent vaccine rollout means achieving herd immunity may not occur as soon as once thought. So, while the calendar has flipped to 2021, the boom/bust nature of 2020 is unlikely to abate for some time.

In a world where fees matter and performance can be boom or bust based on the type of active manager, it makes sense to use a portfolio’s fee budget wisely when making the decision to go active. Based on the returns from 2020, and the historical trends prior, there are more opportunities outside the US as well as within fixed income – leaving US equities largely for beta exposures.