26 Mar 2019
Proponents of the passive, index-tracking approach to equity investing often make their case by underlining the efficiency of stock markets. This is especially true of the US, where research and the speed with which information is translated into price movements can make stock selection a pointless exercise.
The efficiency of a market means the degree to which a share price accurately reflects the present value of a company’s future dividends, assets, goodwill and intellectual capital. The deeper the research, and the more widely discovery is shared at speed, then the less likely stock-pickers are to select the eventual winners and avoid the ultimate losers.
Staying on track
Passive investors point to the US as the most heavily researched market on the planet, and the fact that very few managers deliver consistent alpha, particularly via larger companies – there are fewer of them, and thousands of funds and managers fishing in that pool.
Despite this, in a year where not a single global asset class outperformed the UK inflation rate and the S&P 500 gained less than 1% in sterling terms, UK active managers focused on the US market have achieved some remarkable results both positive and negative, in spite of Q4’s punishing market slide.
The gatekeeper preference for trackers in this sector is illustrated by the top 10 funds by alpha and their relatively few gatekeeper picks. Investec American tops, but is on only gatekeeper list and snapping at its heels is the Baillie Gifford fund with 11 picks. Click here to see more.
Most have just two or three picks, eg T Rowe Price’s Large Cap Growth fund, and two have none at all. The common feature across the top performers was to have a clear focus on the FANG stocks – in Baillie Gifford’s case within a concentrated portfolio of less than 50 holdings.
The fund with the most picks, JPMorgan’s US Equity Income fund (29 picks), almost by definition has to avoid those companies and its performance reflected that, producing a return in line with the S&P 500 from more than 90 holdings. That said, over the first six months of the year the JPM fund increasingly diverged from the index, being adrift by 6% before recouping that by Christmas.
Given that the second-favourite pick, Vanguard US Equity Index (26 picks) delivered the same result with little tracking error at almost a tenth of the price, one has to wonder how managers can possibly generate alpha without making large bets within significantly less-diversified portfolios. The more stocks you select, the more chance performance will be diluted, and the closer your fund’s performance is likely to be to the index.
Generating beta demands a low price. Enhancing those returns with (expensive) alpha requires a focus on a theme (eg technology) or a constraint that restricts selection to perhaps fewer than 50 stocks. The risk is that constraint can go spectacularly badly. Invesco US Equity fund (0 picks) holds around 40 stocks and focused its attention on Basic Materials (oil and energy to you and me). The fund lost more than 10% over the year.