Market rally offers tough lessons for fund managers

Oh, poor fund manager. Why long faces?

July was great! The S&P 500 posted its best performance since the end of 2020, up 9 per cent. It was one of the best months on the market so far. Sure, the withdrawal of generosity by the world’s most important central banks heralds a new wave of volatility in asset prices, but this must be the rebound we’ve all been waiting for, right?

apparently not. Instead, it appears to be yet another pain tradeoff. Bank of America says that despite a spectacular rally last month, only 28 percent of active fund managers focused on large stocks outperformed its Russell 1000 benchmark. All major mutual fund genres underperformed – core, growth and value.

Kudos to the minority, but how did everyone else manage it? All year long, investors have been desperate for a break in the clouds, and finally a bit of a softening signal from the Fed comes along, and they’re still lagging behind their benchmarks. It seems that too much money was tied up in a safe stash of cash and too little money was put on the boom.

BofA analyst Savita Subramaniam and her colleagues said in a note to clients that a bearish trend “could have an impact on performance”. Opportunities to beat the market are still scarce, he said, creating a “tough environment” for funds that choose stocks instead of piggybacking on the index.

One reason for this is that professional investors are not fools. That sign of softening from the world’s most powerful central bank was over-interpreted and came with a far greater warning than the market’s initial reaction.

All Fed chairman Jay Powell said was certainly not appropriate, but certainly not appropriate, to slow down the pace of interest rate hikes in the future. Some market participants took this as a signal to bet on cutting rates and back in stocks that the Fed had spoken hard on inflation. This week, a string of Fed speakers told the markets to calm the cat. He said they are not close to pivot yet and hopes of a rate cut next year are premature.

Column chart of S&P 500 Index showing monthly % change Can the US stock rally continue after the best month since 2020?

Another way to think about it is to question who was doing the purchase. A good chunk of it seems to have come from funds that were extremely bearish, with lots of shorts — or bets against stocks — on their books. Commodity trading advisors – CTAs – such as hedge funds and momentum chasers well-backed riskier assets and then scramble to hold when stocks go higher, a practice known as short covering.

“The equity boom . . . was primarily due to short covering in July,” wrote analysts at Barclays. “The smallest stocks have actually outperformed in Europe and the US.”

An evenly-weighted basket of the 50 smallest stocks in the Russell 3000, “led by a more speculative . . . non-profit name,” has climbed nearly 31 percent since June, says Neil Campling, an equity analyst at Mirabaud. Well, Europe is catching on now.

Anik Sen, head of equities at Pinebridge Investments, is what you call a bottom-up investor who builds a portfolio focusing on a relatively small number of stocks — 30 to 40. Their mission is to choose good stocks and neutralize its impact. Wide move in indices. That task, he says, is increasingly complicated by the larger role played by equity inflows from macro funds and CTAs.

“I have been doing it for over 35 years, close to 40 years. The disconnect between bottom-up and top-down is probably the widest I’ve seen,” he says. “Markets are being moved by macro traders, not you and me. . . .[Their flows]Dwarf compared to fundamental investors. ,

It cuts both ways. Sen is of the view that the July rally is “sustainable” and the markets have been extremely depressed for most of this year. He believes that few corporate stories are much stronger than what investors give him credit for. “We don’t understand why the markets are so negative,” he says, adding that the war in Ukraine, inflation, supply chain tensions and China’s Covid shutdown masked otherwise positive factors.

But mutual funds’ poor performance in July underscores how broad asset allocation has been hinged on powerful macro trends that are railroading stock experts.

My understanding from talking to fund managers is that this is becoming very disappointing. It was wrong for him to be so positive at the beginning of the year and then he missed a trick in July. Now the best approach is probably to be somewhat philosophical.

“You can easily get caught up in short-term movements,” said Mamdouh Medhat, a senior researcher at Quant House Dimensional Fund Advisors, which was founded in the 1980s. “It’s like a ping-pong match and commenting on every hit of the ball.”

Boring it sounds, sticking to the markets for the long term is still almost always the best strategy. “It’s very difficult to beat the market by trying to beat it. People will sometimes make the right call out of pure luck,” Medhat says with the calm tone of a therapist. “Be a fool. . . if you are widely diversified, the only free lunch you are getting in finance,” he says.

katie.martin@ft.com

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