With the timing of further hikes in interest rates by the US Federal Reserve remaining uncertain, many investors are concerned that US equities have entered a new era of increased volatility. Though volatility has eased off during the last few weeks, worries about divergent US monetary policy, disappointment about corporate earnings, and anxiety about the effects of the low oil price, have continued to nag.
Over the twelve months to the end of March 2016, the S&P 500 suffered some quite severe monthly drawdowns. The worst two months were June 2015, when the drawdown was £700 billion, and August 2015 (£600 billion) (see graph). January 2016 was another bad month, with a drawdown of £200 billion in market cap. Though six of the twelve months were positive, with an upswing of £700 billion in October 2015, and the S&P 500 ended up slightly over this period (+2.7% in sterling terms over the twelve months to end March 2016), the bumpiness of the ride has been painful.
Market cap and momentum
Many asset allocators and fund selectors across the globe habitually choose to access the US equity market via an exchange traded fund (ETF) or index tracker. They may do this because of studies indicating that it has historically been difficult for active managers to outperform the S&P 500, or for reasons of cost. While there are good reasons for liking passives, this could turn out to be an inconsistent strategy if investors also fear that volatility in this asset class is increasing. Most passives track market capitalisation weighted indices (sometimes called market value weighted indices), such as the S&P 500 or the MSCI North America Index. Market capitalisation weighted indices are biased toward momentum, because they allocate more to stocks that have already done well, causing their market caps to swell. Is a momentum style what you really want if you believe that volatility will increase? Market capitalisation weighted indices can also have a heavy concentration in the largest stocks, and can sometimes be tilted toward bubble sectors, such as tech stocks prior to the 2000 crash.
Don’t follow me down
Analysing funds according to their up and down capture ratios is a useful way of ascertaining how successfully they may navigate the choppy waters of volatile equity markets. In the graph below, seven well known funds, including three trackers and four actively managed funds, in the North American equities sector are compared over five years to 31 March 2016. The vertical axis shows the up capture ratio, a measure of how well the fund has performed relative to the S&P 500 in up markets. Four out of the seven funds shown have an up capture ratio greater than 100%, indicating that they outperformed the index in up markets. The horizontal axis shows the down capture ratio, how well the fund performed in down markets. As can be seen, though most of the funds shown outperformed the index in up markets, all but the Old Mutual North American Equity Fund underperformed in down markets. Six of the seven funds captured more than 100% of the down move of the index.
Trapped in a style
What enables a fund to outperform in foul weather as well as fair? Part of the answer may be the fund’s flexibility – its ability to switch styles when needed, and to avoid getting trapped by overly persistent style biases. We can all think of fund managers who have had good performance in some market conditions but then run into trouble when those conditions changed: sometimes they have lacked the flexibility to adapt to a new market environment. While a growth style bias has paid off handsomely over the last few years, there is no guarantee that this will continue in the new, more volatile environment. In the year to date, value has beaten growth.
We can measure how funds switch styles, for example between value and growth. A value style emphasises companies whose share prices are low in relation to earnings or book value, or whose dividend yield is high. A growth style is focused on companies that are growing quickly even if their share prices are relatively high. The chart below uses Morningstar’s consistency metric to show the extent to which the seven funds change styles. Funds with higher scores switch styles between value and growth more often, while those with lower scores are more consistent in style.
Whatever your views about future volatility, US equities is not an asset class that can be ignored. It makes up 59% of the value of the MSCI World index. Most asset allocators will want to remain invested in US equities, but many are studying how to do this in new ways. Examining measures such as up and down capture and style consistency can help in finding funds that are able to offer something a little more considered and robust than the index.