Download Market Volatility: a Friend of Active Management?

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Market Volatility: a Friend of Active Management?
By SEI Investment Management Unit
In the current environment, we continue to experience some of the greatest financial market volatility in the modern
investing era. Events of the past couple of years—including the US housing crisis, global credit crisis, skyrocketing
energy prices, declining dollar and overall economic situation—have conspired to give investors a seemingly endless
supply of both up and down days in the market. While this makes for a bumpy ride and sleepless nights for some
investors, it also brings with it a bevy of opportunity for active investment managers with a long-term investment
approach.
In a day and age when many investors have questioned whether active managers can outperform passive
investments—such as passively managed exchange traded funds (ETFs) or index funds, which mirror the benchmark
index — this is exactly the type of environment in which a diversified portfolio of active managers, who seek to invest in
stocks that will outperform the benchmark, could add tremendous value. This commentary will examine the potential
opportunities active management can bring investors in volatile market environments.
What is Volatility?
Volatility means different things to different investors. These days, it is most commonly measured in terms of the
Chicago Board Options Exchange’s measure of volatility in the S&P 500 Index—otherwise known as the VIX Index, and
sometimes referred to as the “fear” index. When this index (which actually measures an estimate of future volatility)
approaches 30, volatility is said to be high.
35
VIX Index (volatility of the S&P 500)
30
25
20
Source: Bloomb erg
15
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
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However, what the VIX fails to capture is the overall investor experience in the market place. We have often used
another measure to better portray this: that being days that major indices (such as the S&P 500) rise or fall one percent
or more in a single trading day. At the time of writing, there had been 65 such days out of a total 158 in the year to date;
or an almost unbelievable 41% of the time. There have even been 23 days that the rise or fall has been 2% or more—
evidence of the bumpy ride for investors. Of the 65 “volatile” days, 29 have been positive days, and 36 have been
negative. While negative days have outweighed positive days, the trend is hardly clear. One thing, however, is clear:
with all the gyrations, the market can not seem to make up its mind; which is the kind of environment in which securities
will tend to be most mis-priced.
And therein lies one of the keys to active manager outperformance versus their benchmarks: the identification and
purchase of mis-priced securities (or sale if the manager is able to sell borrowed securities, also known as selling
short*). Since passive index funds, or passively managed ETFs, are static in nature and hold the same portfolio as the
benchmark, there are no efforts made to analyse securities (determine which are worth owning and which are not) and
then build a portfolio accordingly. That is not to denigrate passively managed investments; they simply are not intended
to deviate from a benchmark, nor are they typically intended to utilise an underlying investment philosophy or framework
in order to identify and purchase (or sell short) securities that are attractive (or unattractive). In return, the underlying
expenses of passive investments are typically lower than the expenses for those that are actively managed.
Active vs. Passive
Passive investing is based on the premise that markets are efficient. Therefore, any and all news or data is reflected in a
security’s current price; so there is virtually no benefit to security analysis, or managers actively building portfolios. This
entire notion assumes the following:
1. Information is available to all market participants
2. Market participants act on this information
3. Market participants are rational
In our experience, these assumptions do not hold up under real market conditions. Information is most certainly not
available to all investors at all times. If that were the case, it would be impossible for all participants to act. Finally, the
studies of Behavioral Finance (of which SEI is a proponent) have shown very clearly that market participants are not
always rational. Therefore, our investment philosophy is predicated on the belief that the markets are not always
efficient, and there are opportunities for skilled managers to capitalise on resulting inefficiencies.
One of the main arguments for passive investing is that it’s cheaper (management fees are significantly lower than those
of actively managed funds), and higher fees make it more difficult for active managers to outperform their benchmarks.
Another key argument is that most active managers cannot consistently outperform their benchmarks. In their favour,
active managers can overweight and underweight securities based on in-depth research and analysis, whereas passive
portfolios are completely dictated by the components of the benchmark. Actively managed portfolios thus have the
potential to outperform their underlying benchmarks; while passive strategies generally tend to only do as well as the
benchmark, less expenses.
It is certainly true that over certain time periods benchmarks and the passive funds that track them have tended to do
better than active managers. A recent example has been the outperformance of the US fixed-income benchmark, the
Lehman US Aggregate Index, versus the average active fixed-income manager during the credit crisis that began a year
ago, according to Lipper data on peer group rankings.
However, as the chart below shows, this fits a pattern of the benchmark doing better during times when government
bonds are outperforming non-government bonds, and thus the spread in non-government over government yields (which
move inversely to prices) is rising. This reflects the tendency of active managers to be overweight in non-government
bonds compared to the benchmark, which has a heavy concentration in government debt (about 22% in the case of the
Lehman US Aggregate Index). However, history suggests that unusually high yield spreads tend to normalise over time,
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or mean-revert, creating opportunities for active managers. When yield spreads decline, benchmark performance has
usually suffered in a similar decline and active managers have outperformed the benchmark.
In other words, higher yields make for more attractive opportunities for active investors as they seek to boost returns in
excess of the benchmark. Investors in a passive index fund will have a substantial exposure to government debt, which
could be at risk not only of missing out on the opportunities that have arisen in other sectors, but could also be at risk of
capital losses if government bonds lose their attraction as a safe haven from market turmoil.
*With short sales you risk paying more for the security than you get from its sale.
Percentile Ranking of Index
Lehman Percentile Ranking vs Peer Group
1.4
Lehman Spread vs Treasuries
1.2
25
Above this line, Lehman index is
outperforming peer group avg.
1.0
0.8
50
0.6
0.4
75
Yield spreads much higher in current credit crisis
vs previous crisis in early 2000s.
Source: Bloomberg
100
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
0.2
Lehman Index Yield Spread (%)
1.6
0
0.0
Jun-08
A similar dynamic occurring in the equity markets during the course of the credit crisis has been the underperformance
of smaller companies, which are perceived to be riskier than their larger counterparts. Given the dominance of larger
companies in the benchmark indices, this has tended to lead the benchmarks toward a higher percentile ranking versus
the relevant peer group of active managers. At the same time, this trend has opened up a larger field of opportunity
where small- to mid-sized companies have been oversold because of general risk aversion, and prices are no longer
reflecting the underlying value of these companies.
Conclusion
While in many cases benchmarks have been outperforming the relevant peer groups of active managers over the past
12 months, there are also reasons for underperformance which are specific to particular funds, and SEI is no exception.
Still, there can be little argument that active managers have the potential to achieve above-benchmark returns.
Strengthening this case is a market environment in which securities are more likely to be mis-priced and markets are,
therefore, less efficient. That appears to be the type of market we are currently experiencing — one where securities are
up sharply one day, then down sharply the next. Here, the best that passive investments, such as index funds or
passively managed ETFs, can generally achieve is the benchmark return, less expenses.
The active manager has greater opportunities. To that end, SEI believes that the most prudent course of action for
investors is to participate in portfolios built with a diversified group of active managers. By building funds that combine
active managers with different investment techniques and a low correlation with one another, SEI believes that investors
can have the best of both worlds: actively managed portfolios that are not too dependent on any one investment
technique for success.
Investment strategy comparisons are for illustrative purposes only and not meant to be all inclusive. There may be
similarities or differences in the funds that are not discussed.
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