The US equity market has thus far in 2016 been notable for a significant divergence between economic fundamentals and investor behaviour. For most of the year, economic data has surprised to the downside, but nevertheless the equity market has been strong to the upside.
The graph below shows the Citi Economic Surprise Index for the US against the returns of the S&P 500 index during the subsequent month. The Citi Economic Surprise Index measures data surprises relative to market expectations. A positive reading means that economic data releases were stronger than expected, while a negative reading means that the data was worse than expected. As can be seen, so far in 2016 the surprises have been largely negative, but equities have gone on to boast positive returns despite this.
Economic data has not let market behaviour this year
What has been driving investors’ behaviour, leading them to put more money into equities despite negative economic surprises? Examining which sectors have done the best this year gives us a clue. For most of the year, sectors whose companies pay out high levels of dividends, such as utilities and telecoms, have performed well. By contrast, sectors whose companies have traditionally been a source of growth, such as consumer discretionary, have performed relatively worse. This suggests that investors, faced by low yields in bond markets, have been chasing yield in equities.
Investment returns have been impacted by the thirst for income
Investors’ thirst for income may thus have provided a stronger impetus to the equities rally than any strong conviction about improvements in economic and business prospects. An argument could be made that the US equity market has become distorted as investors stretch for yield. It is possible that the rally may turn out to be unstable, especially if the US Federal Reserve were to raise interest rates again as it did in December 2015. Though volatility has been low recently, higher volatility (such as occurred in January 2016) could return.
The trouble with trackers
If this line of thought has some merit, one might pause before focusing North American equity exposure in passive index trackers. Although trackers have their place as a cheap way of accessing an asset class, they have disadvantages too. Passives seem simple, but they incorporate style biases due to the way that the indices they track are constructed. Most passives track market capitalisation weighted indices (sometimes called market value weighted indices), that are biased toward momentum, allocating more to stocks that have already done well, and causing their market caps to swell. Is a momentum style what you really want if you believe that volatility could 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.
The style bias trap
Passive trackers are attractive to some investors because most actively managed US equity funds have underperformed the market over recent years. The reason for active managers’ underperformance is, we believe, that most are wedded to persistent style biases. They may have a value style, for example, or a growth style. Value styles have performed well over the long term, but badly over the last five years, whereas growth styles have performed well over that period.
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. Fund managers often have good performance in some market conditions but then run into trouble when those conditions change: they may lack 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 next market environment, which could be more volatile. During 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 above 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.
The extent to which funds change styles between value and growth
Whatever your views about future volatility, it is difficult to ignore US equities: this asset class makes up 60%* 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 style consistency can help in finding funds that are able to offer something a little more considered, and potentially more robust, than the index.
*Source: MSCI, as of 31 August 2016.