by Eric Freedman and David Hood
Diversified investors, which we will define as investors whose portfolios include several different asset categories, such as global stocks, bonds, hedge fund strategies, commodities, and real estate, have not enjoyed diversification’s benefits over the past three to four years, compared to more narrowly allocated portfolios focused on U.S. stock and bond markets. To add insult to injury, active management, defined as a portfolio management style in which the manager makes individual security choices designed to beat a market benchmark, delivered poor performance across most asset classes relative to indexes and passive managers who try to replicate index returns.
To explore this “one-two punch” of underwhelming returns for diversified portfolios and active managers, we interviewed CAPTRUST Chief Investment Officer Eric Freedman and CAPTRUST Head of Manager Due Diligence David Hood to get their insights. Eric manages asset allocation research across CAPTRUST’s business lines, and David oversees active and passive manager research. Eric and David are co-authoring a position paper on these combined issues, which we will publish later this quarter.
Eric, can you explain the basics of diversification and how those principles translate to clients?
Doing my best impersonation of my mother, who was an English teacher, the term invest comes from the Latin word investire, which translates into the English “clothe in, cover, or surround.” I like those last two words when thinking about asset allocation; our goal is to try to surround and cover our clients’ investment objectives with tools that can help them increase their odds of reaching their objectives. Most investors have a goal of more than just retaining purchasing power, so they should invest in assets that will grow their capital beyond inflation’s historical 2–3 percent growth rate.
Because no one, including professional investors, knows what the future holds, we believe in maintaining a portfolio with a variety of asset classes that respond differently to various potential economic conditions and market-driving outcomes. Examples include inflation-protected securities, which are bonds whose principal amounts rise when inflation increases. These securities should act differently than high-quality corporate bonds, which tend to fall in value when expected inflation increases. Recognizing that inflation is not the only factor driving bond returns helps us to think about how they may react in isolation, as well as in tandem with other assets for, a given market scenario.
Our goal is to make sure that clients are not overly diversified, such that each portfolio component cancels out another, but instead that we have created portfolios that will increase the likelihood they can achieve what they want with their capital. Over longer periods of time, diversification into many dissimilar asset classes has led to good outcomes.
So what has happened more recently?
Above we show how a hypothetical diversified portfolio, which is composed of global stocks, a variety of bond types, commodities, real estate, and hedge fund strategies, has performed against a less diversified hypothetical portfolio consisting of 60 percent U.S. large-capitalization stocks and 40 percent U.S. investment grade corporate, mortgage, and government bonds over the past 15 years. The chart shows that the diversified portfolio outperformed the 60/40 portfolio early in the 2000s but has traded leadership in more recent years. Notable market events are highlighted.
As you can see, the performance differences between the diversified and 60/40 portfolios shows some persistent “clustering” but appears to be cyclical. However, over the full time period, the diversified portfolio delivered higher total returns — almost 20 percentage points more. You can see certain time periods in which the diversified portfolio performed better (from 2001 through August 2008, just before the financial crisis), then the 60/40 portfolio performed better for a few years. The diversified portfolio regained the relative lead from 2010 through mid-2011, and then the 60/40 portfolio demonstrated some consistent outperformance for the next two and a half years. Again, relative performance ebbs and flows over time.
Is it fair to say that a push toward dollar-denominated assets, which the 60/40 portfolio owns more of, is the reason why the diversified portfolio typically underperforms the 60/40 portfolio?
Not entirely. U.S. stocks fell within 3 percentage points of international stocks during the financial crisis, so currency alone does not explain the performance differential. The “40” in the 60/40 seems to be what investors demand most emphatically during stressful time periods: government and quasi-government bonds. The bias toward U.S. stocks over international stocks has been especially persistent over the past four years, largely due to the U.S. Federal Reserve’s easy money policies, which have hurt more diversified portfolios. Also, hedge funds and commodities have held back portfolio total returns. Hedge fund strategies, broadly, have made money consistently, just not a lot of it, and commodities have produced negative returns for four straight years.
With the U.S. economy on firmer footing than many international economies, do you think U.S. assets will perform better in the foreseeable future?
That is a possibility, but again, no one is absolute on the future. If U.S. assets perform better, our clients will benefit; the portfolios and allocations we build tend to tilt toward the U.S. despite the fact that the rest of the world’s stocks represent a larger market capitalization. We see U.S. public companies’ accounting standards, governance, transparency, and corporate attitudes toward shareholders as superior to those of non-U.S. companies, so we favor the U.S. with a conscious home-country bias. However, markets and economic growth can diverge. I wish it were as easy as picking the countries or regions that will grow the fastest.
So is diversification no longer relevant?
We think diversification is highly relevant. Different regions of the world are in very different economic situations right now. Central banks are taking on divergent strategies; in some regions interest rates are low and falling, and in other places they are high and rising. Energy price declines help some regions while hurting others. Many scenarios could play out this year, and in a highly correlated global marketplace, having differentiated return sources in a portfolio should help weather the varied outcomes.
While many clients wished they owned nothing but U.S. stocks over the past two years, we didn’t have a single client with the same wish in early 2009 after stocks were cut in half. Over 15 years, diversification has benefited our clients, but over the past four, it hasn’t. As Figure One shows, these things tend to be cyclical.
We continue to look for the right asset classes for our clients. Those asset classes can change over time, but we do not expect to materially narrow the range of assets we think clients should own in their portfolios. Again, we want to cover and surround client goals. More asset classes helps accomplish that goal.
David, what has been going on with active managers?
Active management in areas most widely followed by investors, like large-cap U.S. stocks, has been poor. In other areas, active managers have done well. Fixed income managers, for example, have outperformed their indexes and passively managed funds consistently over the past five years. The difficulty for investors, though, has been that poor active equity manager performance has overwhelmed positive performance in other asset classes. Because of this, active management as a whole has come under scrutiny by clients and advisors alike.
How has CAPTRUST scrutinized active managers?
As a way to cut through the rhetoric and passion and to provide empirical facts about the value of active managers, we studied manager performance over the past 30 years, dating back to the creation of many of the indexes we use today and the beginnings of the mutual funds themselves. We wanted to remove as much bias as possible from our analysis. To do this, we studied large-cap managers’ performance versus their benchmarks and peers and small-cap managers’ performance versus their benchmarks and peers. We also separated growth and value managers to measure them against their respective benchmarks to eliminate any factor biases that may exist in the data. Rounding out the major asset classes, we evaluated international equity managers and fixed income managers.Finally, we analyzed manager performance in rolling three-year increments. Our belief was that reviewing manager returns over a one-year period was too short, and studying manager performance over five-year periods was too long.
What were your findings?
Large-cap U.S. equity manager performance was meager. In the short run, on a rolling three-year basis, 77 percent of large-cap growth managers underperformed their indexes, and 64 percent of large-cap value managers underperformed over the past five years. Small-cap manager results were mixed. During the same period, 61 percent of small-cap value managers outperformed their indexes, but only 39 percent of small-cap growth managers outperformed their indexes. As a result, broadly diversified U.S. equity portfolios underperformed.
International equity manager performance was similar to large-cap U.S. equity manager performance. Overseas, 60 percent of active managers underperformed their benchmarks on a rolling three-year basis over the past five years.
Switching from equities to fixed income, we observed opposite results. Over the past five years, 72 percent of “core” or broadly diversified active managers outperformed their corresponding indexes and passive managers on a rolling three-year basis. The issue for investors continues to be that, while active fixed income managers have outperformed, it has not been enough to offset widespread active equity underperformance. As a result, diversified portfolios with large active components across asset classes have underperformed benchmarks.
What do you look for with passive funds?
There are a number of index funds to choose from that range from global markets to sub-industries within individual countries. The first step in choosing an index fund is to make sure the index it tracks aligns with your investment objectives. In an ideal world, the most important consideration for selecting an index fund would be fees. Your expected return is going to be the return of the index minus fees, so minimizing the fee you pay to the manager maximizes your potential return. However, because even the best index funds do not perfectly track their benchmarks, we must also consider tracking error, or the volatility of the fund relative to its benchmark. An index fund that struggles to match the return of its target benchmark on a consistent basis — a characteristic of higher tracking error — creates undesired risk for a portfolio.
What about the future? Is active management doomed, and is it easier just to invest passively?
The data we analyzed suggests that the average active manager loses to passive management. However, the data is by no means smooth; there appear to be prolonged periods of time during which active managers can add value relative to indexes. Plus, investors need to keep in mind that not all asset classes or strategies can be accessed through passive funds.
Our view remains that this is not an “either/or” choice, and that active and passive strategies can coexist in a portfolio. It is clear from our work that a high hurdle exists for active managers in general, especially in certain asset classes, but our research efforts centered on process and governance can help unearth managers we believe can add value for clients.