Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
GMO on how active managers might be (relatively) more magnificent
It’s been a bad year for US active equity managers. Or make that 10 years. As GMO asset allocation specialists, Ben Inker and John Pease, point out in a new paper, under 10 per cent of active ‘core’ US fund managers outperformed over the last decade.
“… the reason why the S&P 500 and other U.S. large cap equity benchmarks have been close to impossible to beat over the last year and almost as hard to beat over the last decade stems from the nature of the stocks that have outperformed,” the GMO paper says.
In fact, a handful of mega-cap stocks, now known as the ‘magnificent seven’, have dominated US (and global by proxy) share market returns over the previous 10 years in a “practically unparalleled” historical winning run.
“(The mega caps) strung together a series of market-beating performances over the last 10 years, with 2022 being the single year in which they didn’t beat the market,” the study says. “In 2023, as their moniker became part of the common lexicon, they outperformed the S&P 500 by an almost unimaginable 60 per cent.”
But betting on big hasn’t usually paid off for investors with cap-weighted indices trailing equal-weighted benchmarks over the long term as companies move in and out of favour (and existence).
“Since 1957, the 10 largest stocks in the S&P 500 have underperformed an equal-weighted index of the remaining 490 stocks by 2.4 per cent per year,” the GMO report says. “But the last decade has been a very notable departure from that trend, with the largest 10 outperforming by a massive 4.9 per cent per year on average.”
The top seven US stocks now represent 28 per cent of the cap-weighted index compared to just 13 per cent 10 years ago, presenting an even tougher risk-management dilemma for active managers. As the market concentration increases, decisions to exclude mega-caps tend to have a greater impact on tracking error while including such stocks dilutes active strategies.
Inker and Pease argue the mega-problem is particularly acute for long-only managers with “equity extension strategies” – essentially, leveraged long-short portfolios – offering one way, maybe the only way, to square the circle.
“An investor who wants exposure to the U.S. market and a strong style bet today is forced to either take a huge amount of stock-specific risk for or against the Magnificent Seven, or layer a diversified long/short portfolio with their desired style bias on top of index-like equity exposure in an equity extension strategy,” the paper says. “There is no other choice.”
More generally, the GMO pair suggest that US long-only active strategies should be graded against the equal-weighted benchmark.
“If your fundamental active manager keeps lagging versus the equal-weighted S&P 500, that is suggestive of an issue; lagging the cap-weighted benchmark is, for such managers, generally uninformative,” the study says.
Changing the yardstick, though, is unlikely to play well for active managers in investment committee meetings.
“If an investor is truly unconcerned with performance relative to traditional benchmarks, this is less starkly true than it is for investors who care about performance on a relative basis,” the GMO paper says. “But in our experience, the population of investors prepared to ignore a decade of underperformance relative to the S&P 500 on the grounds that they are absolute return investors can be counted on the fingers of no hands.”
Alternatively, GMO says if active managers can survive long enough, a mega-cap mean-reversion is “likely poised to be a tailwind again”.
“The rebound in relative performance for long-only active managers that would follow such a shift wouldn’t be strictly deserved – any more than they actually deserve blame for their failure to keep up with the cap-weighted S&P 500 over the last decade – but it will presumably be welcomed by their clients anyway.”
