Beta Jockeys to Fall at the First Hurdle?

Data* cited in an article by Apollo Multi Asset Management show major global stockmarkets for the five years to 31/12/13 have performed strongly with the S&P 500 index up by about 120%. Even the MSCI Emerging Markets Index was up by 95%. This five year period started after the financial crash in 2008 and barring some set-backs, notably the EuroZone crisis, the trend for equities has been up. I guess it has been a classic bull market.

Apollo argue that “Beta” has been a major driver for equities across the globe with general market exposure more important than the companies being owned. To explain Beta. Simply it is a measure of how a fund performs compared to a stockmarket index. If an index, for example the FTSE All Share index rises by 100% and a UK investment fund that is benchmarked against it rises 100% the fund’s Beta is 1.0. If the fund however rises by 120% its Beta will be 1.2% or if by 90%, Beta is 0.9%. Ideally investors would like a Beta in excess of 1.0 when markets rise and a Beta of less than 1.0 when they fall. Unfortunately most funds don’t behave this, so a fund that outperforms the index in a rally tends to underperform the index in a sell off. Peak to trough volatility is higher.

Apollo argue that some fund managers have been Beta jockeys aligning their portfolios with the index to ride the general upward movement of the market. It has been an easy ride with favourable markets generating good headline performance for the fund managers without too much skill. Another term for a Beta jockey is a closet tracker. These are ostensibly actively managed funds but are largely passively invested by hugging the index. At least an ETF or index tracking fund does what it says on the tin.

However a key observation Apollo made is that the average dispersion between stocks i.e. the disparity in returns between companies in an index has been very low. Good and bad companies have seen their share prices rise. Equities have benefitted from a wall of liquidity from quantitative easing (QE). However easy money is now coming to an end and according to Apollo investors are now more discerning in the companies they invest in – good companies will be rewarded for hitting or exceeding expectations and the opposite for bad companies. If this trend continues in 2014 it will become a stockpicker’s market and talented managers comfortable in taking different positions to that of the index should outperform.

Apollo cite research from Cremers & Petajisto 2009 at Yale University on “Active Share.” This is how a fund’s portfolio differs from the index. They concluded those funds with the highest active share outperform their benchmarks and have the highest persistency of returns. However I have not read their paper nor have information over what periods they measured performance. That said it is my observation as previously reported that index tracking funds tend to do well in steadily rising markets for example over the last five years and during the golden period for equities in the 1980s and 1990s. In periods of volatility, especially where markets move sideways active fund management outperforms. Index tracking by definition is set to fail if the index being tracked starts at a certain level and ends at the same value several years later. It is worth being reminded that the FTSE 100 ended the year in 1999 at 6,930 and more than 13 years later the index has continuously traded below this high. An unfortunate investor in a FTSE 100 tracker at the end of 1999 would of course have received dividends and it is also true other index tracking strategies have been more successful including those following the FTSE 250 and various US indices.

Apollo, a specialist multi-asset portfolio fund manager who pick funds rather than stocks for their portfolios conclude that 2014 will not only suit stockpickers but those fund managers who employ long/short equity or fixed interest investment strategies. This permits funds manager to take positions in companies they like and those they don’t and profit from both sides of the trade. With dispersion of returns set to increase it is important to identify those few fund managers with the necessary skill set to outperform the market in general.

Bull markets always come to an end. This one is difficult to call because it started from a very low base after the worst financial crisis since the 1929 Wall Street crash and subsequent depression. The global economy is still very much in the recovery phase, growth is patchy, inflation is muted and QE life support, although in a tapering phase is still supporting the patient. When the bull market ends periods of volatility and sideward movement of indices is likely to be a hurdle that will cause the Beta jockeys to fall.

*Source: Financial Express from 31/12/08 to 31/12/13 in local currency terms, S&P 500 120.85%, MSCI Emerging Markets 95.53%.

This blog is intended as a general market commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.