Greetings valued clients. We hope this finds you well and enjoying the summer sun to the extent possible. In earlier communications we mentioned our intention to provide commentary monthly through the end of the year. This is the first such commentary. Below we present an update on the state of the economy. Then we delve into a topic that has, for years, been an ongoing debate within the investment industry: the virtues (or lack thereof) of active investment management.
Economic and Market Update
The recovery in capital markets since the end of March has been premised upon a rapid recovery in economic growth from the disruptions caused by COVID-19. One way to measure the pace of the recovery is GDP (gross domestic product) growth, which acts as a governor on overall corporate profits. In the long term and in aggregate, corporations cannot grow profits faster than the growth of the overall economy. When equity markets are trading at above average valuations, as they are now, the pace of GDP growth is an important consideration. A market rally that outpaces GDP growth is not sustainable given the direct connection between corporate profits and stock prices.
The Weekly Economic Index (WEI) from the New York Federal Reserve is a measure that provides insight into the condition of the US economy. While the datapoints are updated weekly, the figure is scaled to represent an annualized period. This helps reduce the inherent volatility of high frequency data and prevents abnormal, short-term statistics (such as a month-long lock-down) from corrupting the outlook. The WEI reviews ten different real time variables including: unemployment, retail sales, electricity usage, steel production, staffing index, railway traffic, tax receipts and consumer sentiment.
The WEI is not as complete as the official GDP report produced by the US Bureau of Economic Analysis (BEA) each quarter, but it is updated more frequently. The BEA released second quarter data on July 30ththat showed an annualized GDP decline of 32.9%, marginally better than expected. The reading assumes that the economic effects of the lockdowns of the second quarter are repeated for an entire year, which explains the significant difference between the WEI and BEA figures explained below.
For the week of July 20th, the WEI showed its first sequential decline since April 25th. The most recent reading suggests no net change in economic activity since June 22nd. According to the WEI, US GDP will fall 7% on an annualized basis for 2020 if current trends continue, an improvement over the 11% reading from April, during the first round of shutdowns.
The July WEI shows that the US economy has made significant improvement from the low point. It also confirms that the economy has lost its momentum due to the resurgence of COVID-19 in many areas of the country.
The WEI is a measure of the output of an economy in terms of GDP. It does not show which individual areas of the economy are growing or shrinking. This level of detail is especially important when an economy is going
through a structural change and is best viewed in terms of corporate earnings. We know the GDP “pie” is shrinking. Actual corporate earnings illustrate how the slices of the pie are changing in size at the firm and sector level. Again, earnings drive equity prices over time.
As of July 24th, 26% of S&P 500 firms have reported second quarter earnings. On average, earnings have been 11.4% better than expected but are still down roughly 42% from the first quarter. This precipitous drop is approximately 2/3 of the worst consecutive-quarter earnings decline experienced during the financial crisis of 2008-2009.
Firms associated with the “home-body economy” such as Netflix, Zoom, Amazon and Microsoft have done very well. Three of the eleven S&P 500 sectors (Technology, Healthcare and Communication Services) have all benefited from the public health response to the virus. The Healthcare and Technology sectors have shown the lowest percentage earnings decline of any sector, other than Utilities, and have produced better quarter-over quarter revenue growth than any of the other nine sectors that comprise the S&P 500. At this point in earnings season, the largest firms in the Communication Services sector have yet to report earnings, but so far, the trend has been generally positive.
The success of the three sectors mentioned above is coming at the cost of the remaining eight. COVID-19 is causing GDP to decline in aggregate, but not in uniform fashion across the economy. Sectors that are well positioned for the “new normal” are faring well. Those that are not, are not.
The Industrial and Energy sectors have experienced earnings declines of greater than 100% quarter over quarter. The share prices of the sectors outside of Technology, Healthcare and Communication services are at the same level today as they were in 2017. Through June 2020, the Real Estate, Industrials, Consumer Discretionary, Consumer Staples, Energy, Utilities, Financials and Materials sectors have produced, collectively, zero equity return over the past three-year rolling period, excluding dividends, on a market capitalization weighted basis.
Capital markets are expected to efficiently allocate capital based upon investment risk and expected return. The fact that 8 of 11 sectors have not earned investors a positive return over the past three years suggests a prolonged period of uncertainty. Until these sectors begin to recover, we are unlikely to see higher levels of employment and consumer spending. Yet without an increase in consumer activity, we are unlikely to see
higher levels of employment. The circular nature of the situation is why another round of stimulus is so important for the economy and capital markets.
The most common sentiment expressed by clients this past month was skepticism about the recovery due to a resurgence of the virus. Aggregate GDP and current earnings data seem to validate the skepticism. The market is rewarding firms with business models that support or benefit from the current social construct. The rest of the market is still priced at recessionary levels and will likely be for some time.
Active vs Passive Debate
Let us start by defining what the “active versus passive” debate is and is not. Proponents of the passive approach believe that index investing is the only valid approach because active managers fail to outperform their benchmarks with sufficient frequency and predictability. Proponents of active management find this argument lacking in several ways.
This debate is not about the virtues of hiring an investment adviser firm such as PIM. Indeed, the investment philosophy of firms such as ours generally falls into one of three categories: 1) active management, 2) passive management, 3) blend. Our approach uses a blend of both active (mutual funds) and passive (index mutual funds and exchange-traded funds) investments.
The Argument for Passive Investing
The most prominent data point upon which the passive argument rests is that in any given year, more mutual funds fail to outperform their benchmarks than produce returns in excess of a benchmark. And this is true, sometimes.
Ben Johnson, of Morningstar Research LLC, published an article on March 6, 2020 entitled “Active vs. Passive Fund Performance: 5 Learnings from the Second Half of 2019”. The five learning are:
- “Active funds’ one-year success rates increased versus 2018 in 14 of the 20 categories we examined. Altogether, around 47% of active funds beat the passive composite for their category in the 12 months through December 2019.”
- “Among U.S. stock-pickers, active small-cap funds saw the biggest rebound in one-year success rates…. 57% of these funds beat the average of the passive funds in their categories in 2019, up from 32% in 2018.”
- “The one-year success rate for active funds in the corporate bond category plummeted in 2019. These funds were hurt by having generally riskier credit profiles and shorter durations than their passive peers, especially during a year when higher-quality credits outperformed and interest rates declined.”
- “The distribution of 10-year excess returns for surviving active funds versus the average of their passive peers varies widely across categories.”
- “On a positive note, our data suggests that the average active dollar has outperformed the average active fund. This implies that investors have favored cheaper, higher-quality funds.”
It is not uncommon for a periodic report such as this to present data that we deem inconclusive. PIM’s Approach
We use both actively managed mutual funds and passive indexes. There are several reasons why we believe this to be the best approach.
- Certain segments of the investment markets are highly liquid, and information on the underlying companies is readily and widely available. The U.S. large-cap stock market is a great example. It is quite a challenge for an active mutual fund manager to outperform the S&P 500. Therefore, we are usually overweight passive investments for this category.
- Not all funds are designed to outperform an index. And/or there is no valid index for the strategy. For example, we may use a U.S. large-cap active strategy that is intended to be low volatility. Comparing the performance of such a strategy to the S&P 500 would be like complaining about the batting average of a professional baseball pitcher. The pitcher serves a critical role on the team but hitting is not that role.
- When you invest in an index, you realize the returns of the index minus a typically small internal expense ratio, but you will also experience 100% of the risk and volatility of the entire sector. If given a choice between an active investment that strives to deliver index-like returns with lower volatility and the index upon which it is based, we would choose the active fund.
- There are certain asset classes that present greater opportunities for active managers. This is especially the case in markets where information on the underlying companies may not be widely and readily available. International small-cap and to a lesser degree emerging markets are good examples. Here we generally use actively managed mutual funds.
- As we have stated in various communications over time, the bond market is large and more complex that the equity market. The domestic bond market index is the Barclay’s Aggregate Bond Index. It is
not terribly difficult to outperform this index using actively managed investments. However, there is one set of economic conditions when it is especially difficult to outperform the index. This is when the economy and markets are in crisis. During periods like this, capital flows into the relative safety of U.S. Treasuries at a frantic pace. Treasuries are a significant portion of the index, so we do typically hold at least a modest position in a passive Treasuries investment. Even then, tactical allocations to active funds can be successful, so we typically surround the passive Treasuries ETF with active strategies.
What drives the process of making the active vs passive decision is identifying an investment opportunity. We are constantly monitoring the global economy and attempting to determine how current trends are likely to impact our portfolios. Once we identify an opportunity, we then search for the best way to implement the idea. We identify and scrutinize both active and passive options with equal consideration. As an independently owned registered investment adviser firm, we have no entanglements with investment product manufacturers and no legacy corporate ideology that corrupts this process.
What follows are select examples of recent active management decisions for client portfolios in custody at Charles Schwab & Co. No investment manager is right 100% of the time. What follows is not a promise or any indication of future investment outcomes. Rather, these illustrate recent decisions and the results thereof.
Guggenheim Total Return
In the second half of 2019 we purchased the Guggenheim Total Return Bond fund. We believed that the US economy was slowing, and we wanted our bond market exposure to be as conservative as possible in the event of a recession. At the time, the Guggenheim fund was one of the worst performing funds in its category for the year and was only mildly attractive over a three-year period. Fund performance was lackluster because the Guggenheim investment team refused to chase a rally in risky corporate bonds, preferring instead to wait for better opportunities. We added to our position in this fund in March of this year. As of July 28th, the fund was up +11.57%, and the Barclays Aggregate Bond Index was up 7.39%. The Guggenheim Total Return Bond fund is in the top 2% of funds in its category year-to-date.
Virtus KAR Emerging Markets Small Cap
Emerging Markets is an asset class that we believe provides opportunities for effective investment managers to outperform the index. In the summer of 2019, we moved away from our former E.M. fund and into the Virtus KAR Emerging Markets Small Cap fund. This year, as of July 28th, the fund is up +9.36%. The Emerging Markets benchmark (as represented by the iShares MSCI Emerging Markets ETF) is down -1.77%. The Virtus KAR fund is in the top 7% of funds in its category.
Artisan International Small-Mid Cap
International small cap is another asset class that we believe provides opportunities for active management success. In October of 2018 we discovered that the lead portfolio manager of our former international small cap fund, which had done very well for clients over time, was leaving the fund. We had the opportunity to meet with him personally and did so. We then liquidated our former holding and established a position in the Artisan International Small-Mid fund. As of July 28th, the fund is up +4.75%. The index for this asset class is down -8.39% for the year. The fund is in the top 36% of all fund in the category.
Morgan Stanley Insight Fund
In early April, coming off the market bottom in late March, we took a careful look at our domestic large cap holdings. Our U.S. Large Cap Growth fund, called Glenmede Quant US Large Cap Growth, was performing roughly in-line with the S&P 500, but trailing the US large growth index. This was not surprising, based upon what we know of the fund. It is really geared to reflect S&P 500 returns with lower volatility. We made the determination at that time that a more concentrated, lower correlation fund may find opportunities in a more fragmented and chaotic market. In the third week of April, we made our initial purchase of the Morgan Stanley Insight Fund. As of July 28th, the fund is up +51.25% and is #1 in its category. Of course, PIM clients have not owned the fund all year. A review of several PIM client accounts suggests that most clients are up approximately 45% on this position. As an aside, the Glenmede fund is up +11.11%, the S&P 500 is up +0.76% and the Russell 1000 Growth Index is up +23.22% as of July 28th.
PAUSE: Most client accounts at Schwab hold approximately 15 positions. We will not present them all. Nor would it be ethical to only present some of the winners. So here are two positions that are requiring of us a little patience.
DoubleLine Shiller Enhanced CAPE Fund
We opened our position in this fund in January of 2017. It is categorized as a domestic large cap blend fund (though was originally domestic large value). This is a fund driven by a quantitative model that regularly rotates into undervalued sectors of the S&P 500. In 2017, the fund returned +21.60%. In 2018, the fund returned -4.02. In 2019, the fund returned +33.82%. The fund outperformed its benchmark each of these years and was in the top 6th, 10thand 7thpercentile, respectively. As of July 28th, the fund is down -4.37% and is in the 74thpercentile. So why do we still own it? Because we understand the nature of the underperformance (related in-part to a collateral pool of high quality, short duration fixed income securities) and at this stage, consider it likely that the underperformance will be temporary.
PIMCO Income Fund
We initiated our position in this fund in late 2012 / early 2013. For the six-year period from 2013 through 2018, its performance was in the 18th, 6th, 3rd, 31st, 10thand 18thpercentiles, in that order. It outperformed its index in each year, sometimes by a significant margin. As of today, the fund is in the 1stpercentile for 10-year performance and the 14thpercentile for 5-year performance. Yet, beginning late last year and through this year, the fund has underperformed. As of July 28th, the fund has returned -0.34% for the year and is in the 63rdpercentile. This fund has provided tremendous returns to PIM clients over time. But recent struggles caused us to sell half of our position in the fund, in all accounts, in April of this year and invest the proceeds into the Axonic Strategic Income fund. Why didn’t we sell it all, you ask? Several reasons, which go beyond the scope of this document, particularly given its length already. But rest assured that if we deem it in our clients’ best interests to vacate the position entirely, we will do so.
What may be gleaned from the preceding? Our views are as follows. Those who contend that passive investing is the way to go cite the inconsistency of active management performance. And they have a case. Not every active fund will outperform its index all the time. And for certain sectors of the global investment markets, doing so is especially difficult. Yet, some strategies are not designed to outperform the index they are stuck with. Another way of phrasing this concept is that for some strategies, there is no benchmark. Further, there are asset classes where outperformance is more attainable, including foreign small cap, emerging markets and global bonds. Finally, skilled investment managers absolutely do exist. Even the most skilled may underperform occasionally, but the best are often consistently effective over a longer investment
time horizon. Our view is that an appropriate combination of active and passive investments can produce acceptable risk-adjusted returns most of the time. We consider it our charge to do exactly this.
Finally, a word about asset allocation. Asset allocation, at the highest level, involves two decisions: 1) asset class determination, 2) investment selection. This discussion has been focused on investment selection exclusively. We did not delve into the topic of asset class determination. Asset class determination is the process of choosing which sectors of the global capital markets to be exposed to at any given time.
For now, especially for our clients with diversified accounts in custody at TIAA and Fidelity, please know this; asset allocation has a greater impact on investment outcomes than investment selection. Our process at PIM is to first determine the asset classes in which we will invest, and their various portfolio weightings, regardless of custodian. We then select the most attractive investments available to fit the risk models we have constructed.
We are aware of a guideline for presentations such as this: “Be brief, be bright, be gone.” Well, we are at the end of this communication, which satisfies one of the tenets. Our hope is that the material we have presented is interesting enough to overcome the “be brief” guideline. As for what remains, we’ll let you decide.
Have a terrific August.
Personal Investment Management, Inc.