The sunlit uplands of volatility

I’ve been reading a lot of reports that this is going to be a good period for active fund managers. Many of these reports, you may be surprised to learn, come from active fund managers themselves.

Intuitively, you would expect a widening dispersal of security returns to be reflected in a wider range of fund returns for the same period, and research does indeed back this up. That doesn’t necessarily work in favour of active management per se, however.

Nevertheless, my innate cynicism aside, volatility can be the stock picker’s friend. Dispersal of returns is supposed to be fertile ground for active fund managers. This stands to reason—if returns are tightly clustered around that of the index, then even the best fund managers will have a hard time outperforming by much, particularly when costs are taken into account. Managers may mitigate these effects by holding off-benchmark positions, often to a high proportion of the portfolio. This works well as long as the wind blows in favour of that chunk of the portfolio, but when it doesn’t and your investors find that the boring blue-chip fund they thought they were holding wasn’t quite that… well, we can all think of examples. And the longer in the tooth we are in this game, the longer that list of fallen stars.

So, let’s stick with the assumption of active managers selecting, more or less, from the index universe. This rule should apply. Of course, the reverse logic also applies, in that if some funds are holding the securities significantly outperforming the benchmark, others hold those underperforming. Unless it’s the legions of Mrs Miggins holding the dogs in her self-select Isa. That’s not the case, as all the average return relative to benchmark over the 20 years is negative for all four indices. This isn’t a screaming buy case for passive fund management, as, barring our Mrs Migginses, some funds have to hold a balance of the losers. It is, however, a case for good fund selection: you need a solid methodology to identify those funds more likely to outperform: something like—shamelessly talking our own book—the Lipper Leaders scores, to pick a randomly chosen example.

Nevertheless, the received wisdom remains that active managers have the potential to deliver outperformance more in periods of high stock dispersal, with one research paper from 2010 finding “The outperformance of the most relative to the least active funds is also concentrated in months of high dispersion.” Is this still the case, and is it true uniformly across markets?

We took the standard deviation of four large equity indices—well-followed ones, to provide the greatest number of funds—as a proxy for cross-sectional return dispersal and how this correlated to the out- or underperformance of the funds^[1] benchmarked to them over a 20-year period. If the thesis is true, outperformance in periods of high dispersal will be indicated by a positive correlation between outperformance and standard deviation. The correlation is positive across three of the four we looked at, varying in strength by index.

The strongest correlation is for the S&P 500 TR (0.43). That’s not a strong relation, but with many other factors impacting on performance, it would be odd if it were. It is, however, positive and not insignificant. The US is, of course, the world’s largest and most liquid equity market. It’s also its most heavily researched one. Next comes the FTSE 100 TR (0.34): again, well researched and liquid, albeit not to the same degree as the US, and then MSCI AC World TR USD (0.27).

However, the MSCI EM Emerging Markets TR USD is negatively correlated (-0.11). It also has the largest average underperformance over the period (-3.52%, with the lowest being -0.09% for the FTSE 100). Note that the average active return relative to benchmark is negative for all indices.

Why is the MSCI EM an outlier? Without digging a lot further, and likely adding some qualitative elements to this quantitative analysis, it’s hard to say. But it could well be that research coverage really does add value. This does suggest that it’s harder to add value through active management in emerging markets, even in conditions of high dispersal where active managers are supposed to come into their own.

Based on this sample, the overall thesis seems to hold up for three out of four of the indices. Of course, it’s not a case of “everybody has won and all must have prizes” in active management; bigger winners, even if more active managers beat the benchmark, also implies bigger losers.

Source: Refinitiv Lipper, from 31/12 2002 to 31/12/2022

[1] The primary share classes of UK registered for sale, actively managed mutual funds