Market rally delivers hard lessons for fund managers

Oh, poor fund managers. Why those long faces?

July was great! The S&P 500 performed its best since late 2020, rallying 9 percent. It was one of the best months on the market of all time. Sure, the withdrawal of generosity by the world’s major central banks is introducing a new wave of volatility in asset prices, but this must be the recovery we’ve all been waiting for, right?

Apparently not. Instead, this seems to be yet another pain trade. Bank of America notes that despite last month’s super-fast rally, only 28 percent of active fund managers targeting large stocks beat their Russell 1000 benchmarks. All major mutual fund styles underperformed: core, growth and value.

Kudos to the minority, but how did everyone else manage this? All year long, investors have been desperate for a break in the clouds, and finally a hint of a bit of leniency is coming from the Fed, and they are still lagging their benchmarks. It seems that too much money was trapped in the safe hidden hole of cash and too little staked during the upswing.

A bearish stance “probably weighed on performance,” BofA analyst Savita Subramanian and colleagues said in a note to clients. Opportunities to beat the market are still scarce, she added, making this a “tough environment” for funds that choose stocks rather than piggyback on indices.

One explanation for this is that professional investors are not crazy. That hint of leniency from the world’s most powerful central bank was vastly over-interpreted and came with far more caveats than the initial market response suggested.

All Fed Chairman Jay Powell said was that it would probably, but not certainly, be appropriate to slow the pace of interest rate hikes going forward. Some market participants saw that as a sign to ramp up bets on rate cuts and return to stocks that had suffered while the Fed spoke loudly about inflation. This week, a string of Fed speakers said markets needed to calm down. They are not yet close to a pivot and expectations for rate cuts next year are premature, they said.

S&P 500 Index Column Chart, Monthly Percentage Change Shows Could US Equity Rally Continue After Best Month Since 2020?

Another way to think about this is to ask yourself who made the purchase. Much of it seems to come from funds that have been extremely bearish, with a lot of shorts – or stock betting – on their books. Hedge funds and momentum hunters such as commodities trading advisors – CTAs – had pulled out well from risky assets and tried to catch up as stocks moved higher, a practice known as short-covering.

“The Revival of Equity . . . in July was mainly due to shortcovering,” Barclays analysts wrote. “The stocks with the most short positions have indeed outperformed in Europe and the US.”

An equally weighted basket of the 50 stocks with the most short positions in the Russell 3000, “led by the more speculative . . . nonprofit names,” is up about 31 percent since June, said Neil Campling, equity analyst at Mirabaud, as Europe is now catching up.

Anik Sen, head of equities at PineBridge Investments, is what you would call a bottom-up investor, building portfolios that focus on a relatively small number of stocks – 30 to 40. His mission is to pick the right stocks and see the effect of broader movements in indexes. That task, he says, is becoming increasingly complicated due to the overly large role played by equity flows from macro funds and CTAs.

“I’ve been doing this for over 35 years, almost 40 years. The gap between bottom-up and top-down is perhaps the biggest I’ve ever seen,” he says. “Markets are not moved by you and me, but by macro traders. . .[Their flows]those of fundamental investors in insignificance.”

This cuts both ways. Sen believes the July rally is “sustainable” and that markets have been too gloomy for much of this year. Some corporate stories are much stronger than investors give them credit, he believes. “We cannot understand why the markets are so negative,” he says, adding that the war in Ukraine, inflation, supply chain tensions and Covid shutdowns in China have masked otherwise positive factors.

But mutual fund’s dismal performance in July underscores how broad shifts in asset allocation, tethered to powerful macro trends, are railroad stock specialists.

When I talk to fund managers, I feel like this is starting to get extremely frustrating. They were wrong to be so positive at the start of the year and then they missed a trick in July. The best approach now is probably to be somewhat philosophical.

“It’s easy to get caught up in short-term moves,” said Mamdouh Medhat, senior researcher at Dimensional Fund Advisors, the quantitative house founded in the 1980s. “It’s like a ping pong match and commenting on every stroke of the ball.”

As boring as it sounds, sticking to markets for the long term is still almost always the best tactic. “It’s very, very hard to beat the market by trying to outsmart it. Sometimes people will make the right calls out of sheer luck,” says Medhat in a therapist’s calming tone. “Be stoic. . . When you’re broadly diversified, you get the only free lunch in finance,” he says.

[email protected]

Leave a Comment