Over the past several years we have repeatedly stated that despite protests to the contrary, the single biggest factor explaining the underperformance of the active community in general, and hedge funds in particular, has been the ubiquitous influence of the Fed and other central banks over the capital markets.
Specifically, back in October 2015, we wrote that “as central planning has dominated every piece of fundamental news, and as capital flows trump actual underlying data (usually in an inverse way, with negative economic news leading to surging markets), the conventional asset management game has been turned on its head. We have said this every single year for the past 7, and we are confident that as long as the Fed and central banks double as Chief Risk Officers for the market, “hedge” funds will be on an accelerated path to extinction, quite simply because in a world where a central banker’s money printer is the best and only “hedge” (for now), there is no reason to fear capital loss – after all the bigger the drop, the greater the expected central bank response according to classical Pavlovian conditioning.”
Several years later, Goldman Sachs confirms that we were correct.
In a note released overnight by Goldman’s Robert Boroujerdi titled “An Rx for Active Management” and which seeks to explain the now chronic underperformance of the “smart money”, the Goldman analyst says he has identified two key considerations impacting the performance of actively managed equity funds including 1) the nature of market regimes and 2) behavioral tendencies of portfolio managers.
Among the various considerations described by Goldman, both market and behavioral, chief among which the observation that alpha is cyclical and that “there have been 4 distinct alpha cycles since 1990, with prior periods of persistent alpha (1990-94; 2000-09) each followed by a respective period of underperformance (1995-99; 2010-2016)”…
… the smoking gun in the report was the admission that “QE has been a headwind… Low Rates, Low Vol, Low Dispersion -> Low Alpha.”
And the punchline: in a slide titled “A word on QE: Does Active Have A QE Hangover“, the simple answer is: yes.
He makes three main points:
1. The current run of active manager underperformance began shortly after the onset of QE (see top-left exhibit).
2. QE drove real interest rates lower (measured by the yield on 10yr TIPS). This trend towards 0%, and even negative, real rates coincided with the shift from active outperformance to underperformance (see bottom-left exhibit).
3. Equity market dispersion and volatility, both key drivers of manager tracking error and excess returns, have remained stubbornly low throughout QE and served as headwinds for manager performance (see bottom-right exhibit).
The slide in full:
Ironically, it has been the hedge fund community which during the current decade has been among the most vocal supporters of first Bernanke and then Yellen, and QE in general. Meanwhile, as central banks “saved” markets, they unleashed the passive, ETF revolution which is the real “great rotation”, as every weeks sees tens of billions in funds shifted from hedge funds and other active managers to low-cost passive alternatives.
What can fix this abnormal market state? Here the answe is also straightforward: a market crash.
As Goldman shows, active investing lags in up markets and outperforms but only in down markets:
- Market upside vs. downside capture for actively managed mutual funds is not symmetric.
- In “up markets” (SPX 1-month return +2% or more), the median active manager underperforms the market by approximately 20bps, on average.
- However, in “down markets” (SPX -2% or more), actively managed funds have outperformed their benchmark by nearly 40bps, on average.
- In the two most significant drawdowns since 1990 (Sept. 2000 – Sept. 2002) and (Nov 2007 – Feb 2009), the median long-only active manager was able to cushion downside and outperform the market.
Which brings us to a conclusion we have stated repeatedly on many previous occasions: while hedge funds, especially established ones with significant AUM, find the current status quo relatively comfortable – after all they get to clip their management fees year after year (forget the “performance” upside), extrapolating current trends in central-bank dominated markets would eventually lead to “active” extinction, and the complete domination of ETF-based and other low-cost passive strategies. Furthermore, taken to its thought experiment extreme, a situation in which there is only passive management would guarantee that the next market crash would be truly unprecedented with few hedge funds there to hunt for bargains.
Ironically, the only event that can break this sequence of events would be a market crash, one which finally ends the current pernicious equilibrium and resets the capital markets. For that to happen however, both the Yellen and now Trump put would have to be eliminated. And that, as the past 8 years have shown, is easier said than done. For the sake of hedge funds and their dwindling assets under management, however, they better fund a way and soon.