If you own a portfolio of stocks, I’ll bet dollars to doughnuts that you aren’t exactly thrilled with your performance lately. Even mutual fund owners have to be wondering why their once market-leading funds are now lagging. The problem seems to be that owning a diversified portfolio of stocks – even top rated stocks – has not been a ticket to success for the last few years.
Think we’re kidding? Standard & Poor’s reported in early March that over the prior three years, the performance of almost 60% of large-cap stock funds trailed the S&P 500 index. Think things are better in the small- and mid-cap arena? Think again. Among actively managed funds, S&P says 70% of small-cap funds underperformed their benchmark and 84% of mid-caps didn’t beat their bogeys.
At issue here is the following combination of factors: (a) The advent of the “macro trade. (b) The increasing use of the “risk on/risk off” trade. And (c) the proliferation of ETF usage amongst the hedge fund community.
On the latter topic, it is no secret that more and more hedge funds and individual investors alike are turning to easy-to-trade ETF’s today in order to get quick exposure to the market. The thinking is simple: Why bother with buying a basket of stocks when you can make one trade (and pay just one commission) and get just about any type of index you want – and you can even get it with leverage, if you are so inclined.
Another factor that can be blamed for the underperformance of diversified stock portfolios is the “macro trade.” Each year, there tends to be a single idea or theme that dominates the market. In 1999 it was tech. More recently it has been commodities, oil, the emerging markets, shorting the market, etc. In short, the dominance of a macro theme causes investors focusing on these themes to invest in only a handful of areas. And if you have big money putting trades into only a couple ideas, a diversified portfolio is going to suffer.
And finally there is what is now affectionately referred to as the “risk on/risk off” trade. This isn’t exactly a new concept in investing as many a manager has made fortunes by getting a “market call” right. Folks such as Marty Zweig, Ned Davis, Elaine Garzarelli, etc. made fortunes for clients and their followers when they got the 1987 “call” right. More recently, a guy named Paulson did OK for himself by betting against the U.S. housing market. However, today the markets move at an increasingly faster pace and the concept of trading on a “market call” has now morphed into something much shorter-term – I.E. the “risk on/risk off” trade.
The idea here is instead of spending time doing company research (which is VERY expensive and VERY time consuming, by the way), traders today simply “put risk on” (via leveraged ETF’s, futures and derivatives) when the news is good and the market is moving up, and then “go the other way” by taking risk off (and/or by putting shorts on) whenever things start to get ugly.
The bottom line here is that using a risk on/off approach is quicker than stocks, easier than stocks, and much cheaper than creating, maintaining and trading baskets of stocks. So, if you are a fast-money type, there is no need to do any research on things as silly as earnings or company fundamentals when you can “bomb in” or out of the overall market or specific indices with the click of a button (or better yet, you can always program the computer to do it for you!).
If this sounds a little like something that was once termed “market timing,” give yourself a gold star. And if you find yourself wondering why a plethora of managers are today implementing a strategy that the mutual fund and financial planning industry spent 20 years convincing you is sheer folly, well, that’s a story for another day (but if you think about the benefits to the mutual fund industry of NOT having folks moving money in and out of their funds, you’ll probably get the idea).
This environment, which seems to favour macro ideas and quickly bombing in and out of leveraged positions based on the headlines, has created an environment where the correlations of stocks to the overall market indices has become quite high – and has stayed that way.
History shows that stock correlations generally rise in times of crisis and fall when the crisis passes. The poster child for this situation was the “Crash of ’87.” Prior to 1987 the 6-month average correlation of stocks to the S&P 500 index was something on the order of 40%. However, during the time following the original computer-induced meltdown, correlations surged to over 75%. This means that three quarters of the stocks in the S&P 500 performed on a one-to-one basis with the S&P 500 index.
Following that period, 6-month correlations fell steadily for many years, finally bottoming sometime in 1994 at around 20%. From there, the correlations varied widely and there were “stock picker” markets to be had.
Then there was the Tech-Bubble Bear, which, as you might expect, caused correlations to rise (this time to about 65% on the 6-month scale) and then fall back again as the “crisis” faded. In mid-2007, the correlations began to rise again. But this time around, the correlations have stuck around – even after the crisis has passed. Thus, correlations have remained high with levels above 75% on a 6-month basis during 2008 and again in 2009/10. And on a twelve-month basis, the current correlation levels are second only to 2008 and 1987.
The point here is that when correlations to the overall market are high, it becomes harder and harder to find stocks that outperform the market – as more and more stocks move in lockstep with the market. So with 6-month correlations now at a point exceeded only by the crises of 1987, 2001, and the recent Credit Crisis debacle, is it any wonder that stock portfolios aren’t outperforming?
As someone who manages money (and a couple stock portfolios) for a living, this concept is not lost on me. And while the current high level of stock correlations as well as the proliferation of ETF and the risk on/off trade is understandable, I think we have to recognise that this is an environment that just might stick around for a while.
It is for this reason that I made some adjustments to my own personal portfolio last fall. In short, I wanted more money allocated to that evil concept of “market timing” and less money allocated to stock picking. Don’t get me wrong, I still have a good slug of money allocated to stocks and our portfolios have performed quite well over the longer-term time frames. But until the current risk on/off environment changes, it might be best to do a little more “timing” and a little less “selection.”