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"Past performance is not indicative of future success." This common disclaimer is generally wise for investors to remember. Such has not been the case in recent periods for domestic equity investors. For the past two years, price momentum has been one of the strongest factors driving domestic equity returns, while value has suffered. This often happens late in market cycles as investors' crowd into the best performers. Index funds have been one of the beneficiaries of this performance-chasing tendency, while many active managers have struggled to beat their benchmark. Early 2016 performance has witnessed a reversal in a number of areas previously experiencing strong momentum. The prospects for active management will likely improve if such trends continue.
At Oxford, we believe both active and passive strategies have a role in domestic equity portfolio construction. Low cost, tax-efficient diversification can be obtained through index funds. Active managers with strong alignment of interests and high active share can outperform by identifying inefficiently priced securities. Each will have periods in which market conditions are more favorable. An environment in which momentum drives markets will favor passive strategies, while value-driven markets generally favor active managers.
Momentum vs. Value
Momentum investing and value investing are contrasting approaches. Momentum strategies focus on stocks with the strongest recent performance. Value investors believe that, all else equal, an asset becomes more attractive as prices decline. Price momentum has been a leading factor driving market returns. In 2014 and 2015, the iShares MSCI USA Momentum ETF increased 18% while the iShares MSCI USA Value ETF increased just 1%. The "FANG Stocks" (Facebook, Amazon, Netflix and Google) were up nearly 70% on average during that time. In 2015, Amazon and Netflix alone accounted for nearly all of the S&P 500's gains, each rising over 100%. In contrast, value stocks were negatively impacted by the decline in energy and concerns of slowing growth, declining 3.5% in 2015.
Active vs. Passive Investing
Active domestic equity managers have struggled to outperform index funds in recent years. Index funds benefit from momentum-oriented markets, while most active strategies do not. Most index funds are market capitalization weighted so as price rises, the weight in the index rises. Stocks benefiting from price momentum, gain increased exposure in the index, while stocks declining have reduced weights.
As is often the case, strong performance drives asset growth. A positive feedback develops as strong performance leads to increasing inflows which fuels even stronger performance. Flows into passive strategies have been strongest near market peaks.
Momentum strategies are indifferent to valuation. The longer a momentum cycle goes on the more extended valuations of momentum stocks become. Nearly all active managers incorporate some valuation discipline. Most active investors seek to add value through bottom-up fundamental analysis to identify businesses trading below their fair value. When momentum ceases to become a driving factor of returns, investors again focus on the fair value of businesses, and active managers tend to benefit.
Many successful long-term active managers have struggled to outperform in recent periods. A study of history would suggest this is not unusual in a momentum-oriented market. We analyzed the performance of top decile large cap managers over the past 15 years. These managers have outperformed the S&P 500 on average by 3% per year for 15 years. This group of managers underperformed the S&P 500 by over 5% in 2015. These managers also trailed the benchmark in the year leading up to the momentum-led market peaks of 2000 and 2007. Following the market peak, their caution was rewarded as they significantly outperform in the years following the market peak and over the full market cycle.
In our conversations with active managers, many are highlighting a bifurcated market, with segments of the markets trading well above their view of fair value while other businesses trade significantly below fair value. The valuation gap between the iShares Momentum ETF and the iShares Value ETF also confirms this valuation disparity.
Investment managers who succeed in the long-term are willing to "risk" short-term underperformance vs. a benchmark to achieve long-term outperformance and attractive risk-adjusted returns for their clients. They do not seek to profit from overvalued businesses becoming extremely overvalued, but rebalance out of businesses trading above fair value into those trading below fair value. Whether active managers seek "value" in businesses with underappreciated growth prospects or businesses in the midst of turnaround, an assessment of the fair value of the businesses should play a role in the analysis.
Some have "thrown in the towel" on active management, as was the case in prior momentum-driven markets. We continue to believe that both active and passive strategies have a role in a portfolio. One of our core principles highlights that risk and opportunity are a function of price and value. The current environment appears to be one in which there are increasing disconnects between market prices and fair value, creating both risks and opportunities. This is an environment in which we believe disciplined and skilled active managers will be rewarded.
The above commentary represent the opinions of the authors as of 2.29.16 and are subject to change at any time due to market or economic conditions or other factors.Print