An investor watches electronic screens in a securities trading house in Taipei as Taiwan's weighted index tumbles more than 2 per cent.PATRICK LIN
Savita Subramanian, quantitative strategist at Merrill Lynch, pointed out on Tuesday that just one in five active U.S. fund managers have been outperforming their benchmark index in 2010, an abysmal track record that says something either about the joys of index investing or the futility of stock picking this year.
Ms. Subramanian argues the latter. Part of the problem for stock pickers this year is that there has been a relatively high level of correlation among stocks. That's because the stock market has been driven by big-picture events - think of Ireland's financial crisis, or potential rate hikes by China, or inventive monetary policy from the Federal Reserve.
"In macro driven markets, stock performance is more clustered, as news typically affects entire industries or asset classes rather than individual companies," she said in a note. "And thus fundamental signals matter less than macro events and news."
As well, she noted that the managers are faced with what she calls a narrow spread: A hypothetical investor who had the foresight to buy the 50 best-performing stocks and sell short the 50 worst-performing stocks would have generated a return of just 35 per cent over the past three months. That's next to an historical average of 50 per cent, and implies that there aren't a whole lot of gains to be made out there, relatively speaking.
And finally, it just so happens that the lowest-priced, less liquid stocks have been delivering the best gains since March, 2009, an interesting development that shuts out many fund managers whose mandates forbid them from investing in these sorts of high-risk stocks.
Ms. Subramanian explains: "For value managers in particular, almost a quarter of the Russell 1000 Value benchmark's returns have been contributed by the lowest priced stocks in the index. This is a grossly disproportionate amount, given that these companies represent only about a tenth of the benchmark weight.
"Low priced stocks, sometimes thought of as distressed equities, are generally less liquid stocks. Large cap funds typically have much larger asset bases and some amount of risk control, and it is thus more difficult for these managers to build an overweight position in the less liquid, and riskier names."
But fund managers can breathe easy. She expects that these obstacles to outperformance will fade as the stock market begins to reflect more certainty about the Fed's direction and the political balance in Washington. As well, periods where correlations are high and spreads are narrow tend to reverse soon after.
"The few times we have seen high correlations and low spreads, the next several years have seen stock selection strategies outperform by a wide margin," Ms. Subramanian said. "The last time correlations were as high and spreads were as low was in late 1987 (coinciding with the market crash), and the subsequent year saw the comeback of fundamentally based stock selection strategies."