Chinese equities have suffered over the past three years, given concerns over geopolitics and China’s economy. Despite several short-lived rallies, the MSCI China All Shares Index remains down almost 50% from its February 2021 peak in US dollar terms. ¹ Fundamentally, for a sustained rally, China needs a rebound in domestic confidence and demand, particularly for the hard-hit real estate and consumer sectors. Although China has taken measures to contain financial risks in its property market, the government’s focus on controlling debt risks imply officials have been cautious in deploying large-scale stimulus to boost growth. Further, policy guidance following the Third Plenum re-emphasized “high-quality” growth as China seeks to build out its strategic industrial and technological sectors (green energy, advanced manufacturing, etc.), and suggests no urgency to tackle current depressed sentiments.

Meanwhile, weaker economic activity in China is translating to deflationary pressures, with July headline inflation only 0.5% year-over-year (YOY), while the GDP deflator was -0.7% YOY in the second quarter. Thus, while nominal interest rates in China appear low, real or inflation-adjusted rates have been high and restrictive on growth.

However, the desire for a stable RMB has limited the PBOC’s ability to ease monetary policy more aggressively. On the contrary, beginning in July, the central bank has taken measures to place a floor on Chinese government bond yields to support the currency, effectively tightening monetary policy. Impending Fed rate cuts may eventually ease pressure on the RMB, but uncertainty over the timing and magnitude of the PBOC’s response remains.

Weaker growth and inflation have impacted Chinese corporate earnings, although the declines seen in trailing earnings and return on equity (ROE) have bottomed out. Analysts’ expectations for Chinese corporate earnings growth in 2024 and 2025 have been revised down but remain healthy at 14.4% and 11.8%, respectively, versus estimates for global equities at 9.8% and 13.6%.

Current valuations for Chinese equities remain very low, especially relative to global equities. As of July, the MSCI China All Shares Index traded at around 10x earnings across the forward price-earnings (P/E), ROE-adjusted P/E, and normalized price–cash earnings ratios. A composite of these metrics is at the 14th percentile relative to history, while valuations relative to global equities have rarely been cheaper. Depressed equity valuations suggest negative sentiments and risks are largely priced in, thus offering significant upside potential should China’s growth outlook improve.

Overall, Chinese corporate fundamentals have stabilized, and equity valuations are attractively priced for significant upside gains. However, unlocking this value requires a rebound in China’s domestic sentiments and demand, which will take time absent additional policy support. The same was the case for Japanese equities during the 1990s and early 2000s; the market would meaningfully outperform global equities when government stimulus triggered growth rebounds in the absence of domestic demand. While China’s caution in deploying more aggressive stimulus is largely tied to its policy priorities, there are also views that the government may be saving firepower until after the US elections to adequately respond to any new policy actions (e.g., increased tariffs on Chinese exports to the United States). Yet, US policies toward China will not be clear until well after the election results and a new Congress takes over in early 2025. Given the uncertainties surrounding China, we recommend that investors be neutral on a tactical basis.

Aaron Costello, Head of Asia

Vivian Gan, Associate Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.

The post Will Federal Reserve Rate Cuts Trigger Outperformance for Chinese Equities? appeared first on Cambridge Associates.

EM versus developed markets (DM) performance cycles are highly cyclical by nature. Over the past nearly 15 years in the post-GFC era, EM equities lagged DM by a staggering 8 percentage points (ppts) per year. A strengthening US dollar, relatively weak EM earnings, and US equity dominance were the primary detractors over this period. However, EM did manage to outperform the DM ex US bloc between 2017 and 2021, highlighting the recent outsized influence of US stocks. EM underperformed broader DM by a similar magnitude in the mid to late 1990s but has also shown the ability to outperform. During the cycle that started in 1999, EM outgained broad DM by a whopping 13 ppts annualized over a nearly 12-year period. Risk-adjusted performance has also been superior to that of DM during relative performance upcycles, despite the higher volatility of EM equities.

Performance cycles tend to be catalyzed by shifts in the macroeconomic backdrop. Just as many investors were wrongfooted by the return of inflation and high interest rates in early 2022, shifting macro conditions can trigger sharp equity market rotations seemingly without warning. A scenario where macroeconomic conditions once again favor EM stocks is not farfetched today. The US dollar’s valuation currently sits at top-decile levels, while economists anticipate a widening in the EM/DM economic growth differential. Coupled with expectations for Federal Reserve rate cuts as early as next month, the potential for a sustained period of US dollar weakening has increased, which would prove a tailwind for EM equities. Finally, the US economy is likely in a late expansion or slowdown phase of the business cycle, where EM’s best performance vis-à-vis DM typically occurs during the following early/recovery stage of the cycle.

Won’t DM equity allocations provide ample exposure to the EM bloc, given the globally diversified revenue base of many DM stocks? This is one argument that has been offered to avoid allocating to EM. However, it does not hold water. According to FactSet, only 23% of DM company revenues are generated in emerging and frontier markets, where China alone accounts for nearly one-third of that total. In contrast, more than 70% of EM company revenues are derived from emerging and frontier markets, suggesting that EM allocations are the best way to achieve true exposure to EM. Further, EM equities themselves are fertile ground for active managers to add value.

Right now, EM equities also help reduce exposure to richly priced US equities. Global equity benchmarks are more exposed than ever to US stocks, which account for a record 65% of global equity market cap. And said exposure does not come cheap. The US market currently trades at more than 21x 12-month forward earnings. By contrast, EM equities trade at a forward price-earnings ratio of just 12x, reflecting a near-record valuation discount. While such a valuation disparity itself does not warrant an overweight stance to EM, investors should continue holding EM stocks as valuations tend to be more meaningful over longer-term periods. Further, we question whether US equity exceptionalism can be sustained, given today’s high earnings per share growth expectations, lofty valuations, and profit margin sustainability concerns.

EM equities may benefit from nascent structural trends over the longer term. These include US/China decoupling, nearshoring, technological innovation and adoption (including digitalization, fintech, and artificial intelligence), and growth of the middle-class consumer. These factors have already been reflected in recent equity returns and a shifting EM index composition. India (14.6%), Mexico (7.3%), and Taiwan (7.2%) have all outperformed DM equities (6.8%) over the prior three years, while China’s weight is down nearly 20 ppts, from a peak of 43% in 2020 to just 25% today. ASEAN countries have already started to benefit economically from shifting supply chains, and we expect that potential for increased foreign capital flows will create tailwinds for these equity markets over time.

Investors tempted to abandon EM equities altogether would be wise not to extrapolate the recent past into the future, as they may yet benefit from EM equity allocations at subsequent turns in the cycle. In the meantime, EM equities offer a wide opportunity set for skilled active managers to add value. We remain neutral on EM equity allocations today and recommend investors hold these allocations in line with their weight in global equity indexes, having recently closed an overweight recommendation to Chinese stocks.

Stuart Brown, Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.

The post Do Emerging Markets Equities Deserve a Place in Public Equity Portfolios? appeared first on Cambridge Associates.

Japanese markets have been the most eye-catching in this current bout of turbulence. After the yen reached an all-time low of nearly ¥162 to the dollar in early July, it has since strengthened by 12.6%. A compression in interest rate differentials, driven by both soft US economic data and hawkish Bank of Japan decisions, contributed to the large yen appreciation. This move caused many so-called carry trades—which relied on a weak yen to fund positions in high-yielding assets—to unwind. In addition, Japanese equities had been a very popular macro trade, leaving it exposed to a large deleveraging event. This is evident in the 20.3% decline in the Tokyo Price Index (TOPIX) over the last three trading days.

Other equity regions have sold off as well, although to a significantly lesser extent. Most meaningful for portfolios is the United States, due to its sheer size, connections to the carry trade, and concerns about its economy. The economic anxieties have most recently been centered on the labor market, where the unemployment rate has steadily risen, as have jobless claims, while job growth has slowed. While most, if not all, of these metrics are at otherwise normal values from a level perspective, the concern is that they may continue to deteriorate. For example, the Sahm rule, which was recently triggered, highlights that a 0.5-percentage point rise in the three-month average unemployment rate from its recent low has always led to a further material rise in unemployment and, ultimately, recession. This is a statistical regularity with a small sample size and not a law of nature. So, it is possible that the unique context of this economic cycle will disrupt that relationship. Indeed, most of the rise in unemployment has been driven by an increase in labor force participation, not layoffs, and the US economy grew by 2.8% in the second quarter and July’s composite Purchasing Managers’ Index points to continued growth for the month. Still, the Federal Reserve has ample room to respond to economic weakness, with futures markets increasing their expectations in recent days from three 25-basis point cuts by the end of 2024 to five.

In addition to economic data, US equities have also been impacted by second quarter earnings results. The central role that earnings expectations for tech stocks have played in this year’s rally meant that this season’s “Magnificent 7” results were closely scrutinized. While headline revenue and earnings results were generally solid-to-good, the market nonetheless took fright at the scale of the capital expenditures that these firms remain committed to making to achieve their AI-related objectives. The elevated valuations of some firms left them exposed to any reappraisal of the transformative effect of AI initiatives on their future earnings. As a result, the tech-heavy Nasdaq Composite was down 13.3% below its recent peak during trading today, while the broader S&P 500 Index was down 8.6%.

Given the equity sell-off, the temptation may be to cut equity risk to avoid additional losses. But we view all bets through the lens of probability, and cutting equity allocations for, say cash or bonds, has not been a high probability bet historically, even in periods of high volatility. By shifting meaningfully from stocks into cash or bonds, investors could also concentrate value added performance into one decision, overwhelming all other sources of value add, such as those linked to individual managers. Last, and relatedly, when markets move violently in one direction, they tend to correct violently in the other direction. So, cutting equity risk now could lock in large losses relative to policy that could weigh on portfolios for years.

Instead, we believe investors are best served by relying on a well-constructed asset allocation, sticking to any pre-determined rebalancing policy, and monitoring liquidity sources and needs. We continue to favor modest overweights in developed markets value and small-cap equities, both of which have compelling valuations and earnings outlooks with more upside potential relative to broad equity markets. We also believe investors should continue to hold high-quality defensive assets, such as long US Treasury securities. While long Treasury securities are less attractive today than a week ago, given the large drop in yields, we continue to see value in holding an overweight position in the next weeks given the potential for economic weakness and market volatility.

Stepping back though, chaotic periods always remind us of a key maxim—thoughtful decisions, not rash actions, are what separate top-performing investors from everyone else.

Kevin Rosenbaum
Head of Global Capital Markets Research

Thomas O’Mahony
Senior Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.

The post Should Investors Alter Portfolios Considering the Equity Market Rout? appeared first on Cambridge Associates.

While the Labour Party have been given a mandate to govern, it is less obvious that they have been granted a mandate for substantial fiscal change, given the cautious manifesto upon which they campaigned. For instance, Labour has committed to two budgetary rules: (1) debt-to-GDP should fall by the fifth year of budgetary forecasts; and (2) the current budget should be in balance on the same time horizon. While the still-vivid memory of the Truss/Kwarteng era fiscal plans is likely enough on its own to inhibit attempts at serious unfunded expenditure, spending will likely be further constrained by the party’s commitment not to raise income tax, national insurance, corporation tax, or VAT. This leaves few other options to raise taxes to finance increased spending.

Labour plan to enact several reforms to increase productivity growth, which has been a source of much of the United Kingdom’s economic malaise, albeit one shared by many developed markets. For a start, they plan to build 1.5 million new homes over the next five years, more than 60% above the average completions rate of the last decade. Labour are also aiming to streamline public infrastructure planning, as well as commercial and industrial projects within growth industries. They believe there is also scope to materially increase private sector investment in both capital projects and broader capital markets. A period of economic stability would be a tailwind to boosting such investment, while Labour have also suggested they may look toward consolidation of smaller pension funds as a potential further source of capital investment. Finally, after being partially relitigated at the 2019 election, Brexit was notable by its absence as a central Labour campaign topic during this election. Indeed, Labour have ruled out rejoining the single market or entering a customs union. However, they will likely attempt to eventually deepen ties with Europe via measures such as removing non-tariff trade barriers and fostering alignment on standards.

Structural reforms are by their nature slow and challenging to implement. Even if their execution is successful, it will be at least a couple of years before there is a discernible growth impact. With Labour’s hands largely tied from a fiscal perspective, if partly by their own choice, this election’s short-to-medium impact on economic growth is therefore likely to be modest. Similarly, we expect the market impact to be muted in the near term given both this growth backdrop and how long a large Labour victory has looked assured. Still, UK equities trade at a significant discount to their peers (our preferred valuation metric shows UK equities trading on a multiple of 7.4x versus 17.0x for broad developed markets) and a shift in sentiment could catalyse some catch-up performance. However, we await more concrete signs that the fundamental backdrop is improving and continue to recommend holding UK equities in-line with policy weights.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.
2. Two seats had not been declared at the time of writing.

The post Labour’s Big Win to Result in Policy Evolution Rather than Revolution in the UK appeared first on Cambridge Associates.

Transformative technological innovations fundamentally change how we live. Previous innovations led to impressive productivity gains in the 1960s and 2000s. In the 1960s, with significant advancements in semiconductor chips, we swapped clunky mainframes for faster, more convenient minicomputers. In the 2000s, penetration of the internet—followed by the advent of the smartphone—built on innovations from the prior decade. However, productivity gains in the 2010s were disappointing. While accurately identifying and measuring productivity drivers is fraught with uncertainty, the disappointing 2010s trend may be partially explained by the fact that innovations during this period were incremental rather than transformative. It may also be the case that gains were challenging to incorporate into data. For example, certain digital services that were previously paid for are now free on the internet, thus, understating economic output.

We think AI represents a transformative opportunity, which could lead to enduring productivity improvements. The proliferation of AI assistants is already underway. Higher profitability from increased efficiency will benefit businesses across the economy, particularly those relying heavily on manual in-office tasks. Currently, companies bringing AI solutions to market, such as chip manufacturers, are enjoying record revenue increases. Demand is also soaring for associated software, cloud computing, data centers, and power generation.

History shows that investors become extremely optimistic about future growth options from new technologies. This can lead to a market frenzy, which creates asset-price bubbles that inevitably culminate in bubbles bursting, much like the “dot-com” bust. That cycle provides an extreme example of exuberance; the US tech sector soared 53% on average per year in the five years ended March 2000 (the cycle’s peak). In retrospect, earnings growth forecasts were much too optimistic. At the cycle peak, analyst estimates for 2001 growth were 73 percentage points higher than the level of growth that was realized. Furthermore, peak-to-trough, equity investors lost 80% and it took 16 years to retrace to peak levels. A sobering reset indeed.

We do not think the current AI rally will follow the path of the dot-com bust, given businesses have healthy balance sheets and real earnings this time around. But we do think investors should diligently monitor the risk/reward balance going forward. Overall, valuation of the US tech sector—which makes up nearly 90% of the developed markets IT sector—has expanded from a 26x normalized price-to–cash earnings multiple in December 2022 to 41x today. This is staggering relative to the developed markets index, where the multiple only increased by 3.2x. Still, some of this optimism has been warranted. While AI darling Nvidia’s stock rally of over 600% in the same period and trailing price-to-earnings multiple expansion from 62x to 72x is incredible, results and forward guidance have repeatedly exceeded analyst expectations.

Nonetheless, investors should be mindful that uncertainty exists. One reason is that reality could disappoint versus expectations as there will inevitably be errors in forecasting the magnitude of productivity gains. Disappointment could come in many forms. For instance, we do not know how AI will displace existing technologies, rendering them obsolete; to what extent the labor market will suffer from lost jobs; or how regulations will curb use cases for AI. Another source of uncertainty is the time lag between the very large investments needed to support AI growth and realizing the intended benefits.

Taking this altogether, we advise modest tilts to market segments with more reasonable valuations such as small-cap and value equities. The normalized price-to–cash earnings multiple for developed markets small-cap equities, for instance, is the least expensive it has been relative to developed markets equities over the last 20 years. Similarly, the relative valuation of developed markets value equities versus developed markets equities sits at the 8th percentile of data over the same time period. Let’s not forget, these recommended strategies will also benefit from AI-driven productivity gains, even if their current prices don’t reflect it!

Sehr Dsani, Senior Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.
2. Two seats had not been declared at the time of writing.

The post Will Artificial Intelligence Continue to Propel the Market Forward? appeared first on Cambridge Associates.

Over the last four years, the Japanese yen has consistently weakened, experiencing a 34% decline against the dollar since the end of 2020, and comparable depreciations against the euro, UK sterling, and Swiss franc. Currently, the yen’s real effective exchange rate is at its lowest since December 1971, standing at the 4th percentile of observations since 1970, with a 36% undervaluation compared to its historical median.

Widening interest rate differentials between Japan and its peers lie at the heart of this broad depreciation. The COVID-era inflation surge occurred earlier in other markets, which resulted in central banks raising rates aggressively in those regions. Meanwhile, the Bank of Japan (BOJ) maintained monetary policy at extremely accommodative settings for a prolonged period as a result of both a delayed exit from lockdowns and secularly low domestic growth. Indeed, they have only recently exited what may be termed ‘emergency settings’ by ending their explicit yield curve control policy and taking rates out of negative territory.

Japan’s first quarter GDP contraction of 0.5% suggests near-term policy tightening is unlikely. Nonetheless, with policy rates in peer regions at cyclical highs, and limited room for the BOJ to ease, a narrowing of interest rate differentials is the probable direction of travel. Most developed markets (DM) central banks are likely to reduce rates from their current restrictive stances and bring them back towards a more neutral level. When weak growth in certain regions is added to the equation, that potentially accelerates the timeline over which easing will occur. This process has already begun in Switzerland and Sweden and may kick off in the Eurozone and United Kingdom as soon as next month. The muted pricing in of cuts in the United States also points to the potential for a narrowing of rate differentials. What’s more, Japanese authorities have shown intent to intervene to strengthen the yen when it has approached 160 to the US dollar, a level that is approximately 2% away.

The weakening yen has provided a dual benefit to Japanese companies’ earnings. It has enhanced the competitiveness of exporters by making their goods and services more affordable internationally, and it has boosted earnings directly through the favourable translation of foreign revenues back into yen. This earnings backdrop has driven strong local currency outperformance. However, for non-Japanese investors, the impact of holding assets denominated in a depreciating currency has largely neutralised these local currency gains, resulting in a performance that is broadly flat when measured in US dollars. Hedging out yen currency risk has worked well in this environment, with local currency outperformance supplemented by positive carry from the hedge. While this can persist with a weakening or range-bound yen, such a position is exposed to a sharp strengthening of the currency. The EPS tailwind would become a headwind, without the benefit of the strengthening yen as an offset.

While we do not foresee Japanese equities continuing to benefit from a weakening yen, and relative valuations are not compelling, other factors may continue to serve as tailwinds. Foremost amongst these are the reform efforts being promoted by the Tokyo Stock Exchange (TSE) to improve capital efficiency and corporate transparency. Corporate engagement with these efforts has surpassed prior instances of attempted reform, with 57% of TSE Prime listed companies now having disclosed their planned initiatives. The actual and expected tangible results of these reforms include the increased return of capital to shareholders via dividends and buybacks, a reduction in cross-shareholdings, and a continued increase in the proportion of independent directors on boards. Additionally, a trebling of the Nippon Individual Savings Account allowance, which allows residents to invest in financial assets tax free, should be a source of greater inflows into domestic equities.

The TSE reform initiatives especially should be of particular benefit to Japanese small caps. Therefore, while we remain neutral on Japanese large caps, we see conditions in Japan as a tailwind to our DM ex US small-cap position, which counts Japan as its largest regional exposure.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.
2. Two seats had not been declared at the time of writing.

The post Will the Yen Continue to Support Japanese Equities? appeared first on Cambridge Associates.

The Median Manager Will Not Suffice

The median manager has delivered rather pedestrian returns in excess of its benchmark, but there are plenty of managers that have delivered meaningful excess returns over time. More specifically, since 2011, ³ the median global manager has delivered an average, gross of fee, rolling three-year excess return of 0.6% and the median US large-cap manager has fared even worse at -0.1%. Taxable investors require even higher returns to outperform the market net of fees and taxes as index funds tend to be more tax efficient than active managers. For such investors, we lean into tax-efficient managers that can also harvest losses and generate “tax alpha.” In short, to earn excess returns of 30 basis points (bps) to 40 bps net of fees requires finding managers well into the top half—closer to the 35th percentile for US large caps and 45th percentile for global equities.

Managers trafficking in less efficient markets (whether that means less in the way of sell-side coverage, buy-side product offering, or tech-enhanced transparency), such as small caps and emerging markets, have fared better over time. The following data show that in contrast to more efficient US large-cap equity managers, the median manager in such strategies has offered value even after fees, with the average of rolling three-year, gross value–added returns of 1.4 percentage points (ppts) for US small-cap managers and 1.1 ppts for emerging markets managers.

Structural Challenges

Understanding the hurdles active managers face can help provide insights into ways to improve the odds of outperforming the market. Challenges include the tendency of even the best managers to experience meaningful periods of underperformance, index concentration, and shifting manager characteristics. More recently, investors have raised concerns that the rise of passive investing has made it more difficult for active managers to outperform, while we see passive’s ascent as more of a mixed blessing.

Even the Best Managers Underperform Periodically

Identifying managers that can outperform the market is challenging because those that outperform during one period do not always repeat this feat. Indeed, most managers reporting performance at the start of 2011 either underperformed their benchmark during the majority of rolling three-year periods or stopped reporting, which typically happens due to liquidation, mergers, or poor performance.

Our 2018 study of active US equity managers from 1996 to 2016 found that only 27% of the 1,368 managers reporting performance in 1996 survived for the entire 20-year period. Of those 370 survivors, 85% outperformed the relevant style index. These 317 winners did not outperform over every short-term period. Most underperformed their relevant style index by a considerable margin from time to time, with 60% underperforming for three consecutive calendar years, and more than 90% underperforming in two consecutive calendar years at least once. The underperformance was often severe. On an annualized basis, 18% underperformed by 10 ppts or worse over three years and by more than 5 ppts per year over five years.

Positive Skew and Concentration Risk

Positive skew is another challenge for active managers. Return distributions from long positions in equities tend to have long right tails (positive skew) because single-stock negative returns are capped at -100%, while positive returns can exceed +100%.

Positive skew impacts most long-only managers that hold more concentrated portfolios than the underlying benchmark. According to research by Ikenberry, Shockley, and Womack, without exceptional skill, the odds are incredibly low that an active manager investing in S&P 500 constituents will hold one of those stocks with extremely high returns. This drag from skew is lessened when funds hold more than 35 stocks but is still present even when a portfolio holds 150 stocks. ⁴ Historic performance data studied by Petajisto further underscores the challenge. ⁵ His work revealed that the top 20 performing stocks in the US equity market over a five-year period subsequently underperformed the broad US equity market over the next ten years. This underperformance was consistent and meaningful. The median of prior stars underperformed in nearly 86% of monthly rolling periods since 1926 by a cumulative 17.8%, or nearly 2 ppts per year. It is difficult to strike the right balance between holding concentrated positions and capturing enough of the tail of positive returns.

Concentration of outperformers doesn’t pose a significant challenge to active managers when the best performers have low index weights, but when they are concentrated in the largest stocks—as they have been in recent years—the index is a particularly tough bogey to beat. For example, in 2023, the number of stocks outperforming the S&P 500 Index was unusually low (29% versus a median of 49%) and gains were highly concentrated in a handful of mega-cap stocks, with the top ten companies contributing 62% of the index’s return. Concentration in the top ten stocks for MSCI ACWI last year, however, stood at 42%, and the share of stocks outperforming fared slightly better at 34%. Over a longer-term period, the global index has a higher share of outperforming stocks with a median of 50%.

Shifting Manager Characteristics

A key challenge in building portfolios of active managers is avoiding unintended bets as a byproduct of manager selection, given their underlying exposures tend to drift over time. Manager exposures shift across the capitalization and factor spectrum (e.g., value, quality, momentum) as well as geographic, economic sector, and currency exposures. The following figure shows how the average growth and value manager’s style characteristics tend to shift over time. ⁶

The Rise of Passive—Is Passive Harder to Beat?

A key question for investors is if the increase in passive investing has changed active managers’ ability to outperform by altering market efficiency. To earn excess returns, skilled (or lucky) managers must outperform the market at the expense of those that underperform. Skilled active managers have an easier time outperforming in less efficient markets with a higher share of unskilled investors. Overall, markets are more efficient today due to the proliferation of lower cost access to uniform information through technological and regulatory developments. These developments have diminished managers’ ability to consistently secure an informational edge to make excess returns.

As index funds have become more prevalent, the share of ownership and trading by price-insensitive buyers has increased, providing potential for more inefficiencies. Buy/sell decisions are less driven by deep research on stock-specific fundamentals and more so by aggregate factor data that are increasingly traded as a portfolio. Their price insensitivity can amplify market moves, leading to price instability, and creating dislocations (market inefficiency). This is especially true when passive trades account for most of the volume on any given day. Further, the transition of funds from active to passive pushes relatively more capital into mega-cap index constituents. This happens as index funds receiving capital move to fully invest, replicating market-cap weighted indexes as quickly as possible. These funds buy and sell holdings as capital flows in, and they trade to match shifts in index constituents. Active managers, in contrast, tend to hold some cash and are more price sensitive, often taking their time to put capital to work, favoring more attractively priced stocks and holding more equal-weighted portfolios.

Over the last decade, growth in assets under management in passive strategies has been phenomenal, but the vast majority of global equity market cap continues to be actively managed. Among global mutual funds and ETFs, passive strategies now account for more than half of assets, yet such vehicles account for a minority of global equities as a whole. Chinco and Sammon ⁷ estimate that passive ownership of US equities is nearly 35% of total US equity market capitalization based on analysis of trading activity around index reconstitutions. ⁸ In short, passive investing has accelerated, yet the majority of the market continues to be actively managed, driving price discovery.

The shifting market structure resulting from capital moving from active to passive management likely contributes to the outperformance of the largest stocks, increasing market concentration, and making it more difficult for active managers to outperform the market in the near term. However, active management remains dominant, and to the degree that the rise of passive accentuates crowding and concentration, it also opens up investment opportunities for skilled active managers. The rub is that it may take more time for the value to be realized.

How Can Investors Improve Outcomes?

Employ a Robust Research Process

Manager selection requires thoughtful consideration of qualitative and quantitative factors over a broad range of characteristics. Manager skill and the ability to survive through cycles appear to be the most important determinants of long-term success. Dedicated fund researchers should focus on these features as they are far more important than analyzing short-term performance. Indeed, the distribution of survivors and non-survivors in terms of percentage of years they outperformed their style index is quite similar. Therefore, assessing the competitive edge and the degree to which the investment process is repeatable are critical.

As the technology and regulatory environment have leveled the playing field for accessing corporate information, managers must work harder to gain an edge. Technology acumen (e.g., data scraping, satellites) can provide an advantage, but managers must continually invest to maintain their lead. Experience and judgment also go a long way to set managers apart. From an organizational perspective, we advise partnering with firms with good governance, alignment of principal and agent issues, strong firm culture, and a high caliber and well-diversified customer base. Securing fee structures that enable investors to retain most of the excess returns also increases the odds of earning excess returns over the long term.

Exercise Patience

Recognizing that even managers with terrific long-term records suffer from periods of underperformance and that the pattern of excess returns tends to be cyclical, it is important to take a patient approach with active managers, assuming that the initial and ongoing due diligence of the investment manager is sound. This in-depth work should encourage investors to stay the course and ultimately fight the behavioral tendency of firing after a period of poor performance. In our experience, one of the biggest mistakes investors make is firing good managers after near-term underperformance. Consider that the dollar-weighted returns of institutional shares of mutual funds are much lower—nearly 200 bps—than the time-weighted returns that the funds report. This is because investors, even institutional ones, tend to sell managers when they are at or near their lows and buy in after a run of good performance.

Construct Well-Balanced Portfolios

The ongoing drift in manager factor exposures creates portfolio construction challenges that can be as important as manager selection. A simplified case study will help illustrate the challenge. Consider a US equity portfolio benchmarked to the MSCI US Index and consisting of an equal-weighted allocation to two managers—a growth manager and a value manager. On initial inspection, it appears they are well balanced, meaning that their combined style exposure would mirror that of the MSCI US Index. Yet in 2021, the value manager drifted to growth as growth outperformed. Once 2022 brought rising interest rates that killed the growth rally, both the growth manager and the value manager underperformed the broad market even as the value-style benchmark outperformed. The result was 18.4 ppts of cumulative US equity underperformance for 2022 and 2023. While an extreme example, given the unusually sharp shift from growth outperformance to value outperformance over this period, this case study illustrates the challenge investors have in managing portfolio exposures and the requisite risk management.

Because of the value manager’s style drift, the portfolio included both an intentional bet on the manager’s skill relative to its value benchmark and an unintentional (and poorly timed) bet on growth relative to value. Based on index exposure, an equal-weighted growth and value portfolio matches the style exposure of the broad index as shown in the bottom panel below. The out- or underperformance of the styles relative to the broad market nearly offset each other perfectly. Yet, when using active manager implementation, potential for style drift opens the door to unintended factor bets.

Investors should study the return attribution of managers to evaluate if managers are skilled in factor rotation. If so, outsourcing factor positioning to such managers is appropriate. Otherwise, investors should maintain factor exposure consistent with the broad market (unless implementing tactical positions). To do so, investors must continuously monitor manager exposures. In the above example, reducing the growth manager allocation or adding to value exposure (active or passive) would have proved beneficial.

Another alternative is to focus on managers that seek balanced exposures relative to their index, adding value through stock selection in a more risk-controlled manner. Including 130/30 managers ⁹ in the long-only public equity portfolio provides a means of including active managers with tight risk controls relative to their benchmarks. Such managers relax the constraint prohibiting shorting, while maintaining net equity exposure of 100%. This approach may help address the challenge of positive skew and concentration. First, these managers can hold more positions than the average long-only manager, increasing their odds of exposure to stocks that outperform. Second, such managers can take more meaningful underweights through shorting securities with tiny index weights that offer limited upside when excluded from long-only portfolios—as of year-end 2023, 86% of securities in the MSCI World Index had weights of less than 10 bps.

In sum, investors need to recognize that drift is a feature of active management requiring ongoing monitoring and management. Investors should find the best active managers that can add value relative to the market and incorporate them into an ensemble that provides a superior orchestral experience. Looking at how individual managers perform relative to the benchmark most closely representing their style is inadequate. It is critical to also consider how the combined set of managers perform relative to the broader market. Too many strings and not enough brass will create an imbalance that will disappoint audiences regardless of how superior the individual musicians are.

Conclusion

Building outperforming portfolios in long-only equities is hard work but worth the effort. Engaging in deep research to identify firms with a repeatable competitive edge and strong organization that can stand the test of time is far more relevant than analyzing short-term performance. Selecting the right managers is only the first step. Constructing portfolios requires careful consideration of manager and market dynamics to adjust for shifting factor exposures and avoid unintended bets for which investors are unlikely to be compensated.

Celia Dallas, Chief Investment Strategist

Sehr Dsani, Senior Investment Director, Capital Markets Research

Grayson Kirk, Graham Landrith, TJ Scavone, and Eric Thielscher also contributed to this publication.

Nasdaq 100® Index
The Nasdaq 100® Index is one of the world’s preeminent large-cap growth indexes. The companies in the Nasdaq 100® include 100+ of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market® based on market capitalization.

Russell 1000® Index
The Russell 1000® Index measures the performance of the large-cap segment of the US equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® represents approximately 93% of the Russell 3000® Index, as of the most recent reconstitution. The Russell 1000® Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are included.

Russell 1000® Growth Index
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000® companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium-term (two year) growth and higher sales per share historical growth (five years). The Russell 1000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

Russell 1000® Value Index
The Russell 1000® Value Index measures the performance of the large-cap value segment of the US equity universe. It includes those Russell 1000® companies with relatively lower price-to-book ratios, lower I/B/E/S forecast medium-term (two year) growth and lower sales per share historical growth (five years). The Russell 1000® Value Index is constructed to provide a comprehensive and unbiased barometer for the large-cap value segment. The index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect value characteristics.

Russell 2000® Index
The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 7% of the total market capitalization of that index, as of the most recent reconstitution. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

Russell 3000® Index
The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 96% of the investable US equity market, as of the most recent reconstitution. The Russell 3000® Index is constructed to provide a comprehensive, unbiased and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are included.

S&P 500 Index
The S&P 500 Index includes 500 leading companies and covers approximately 80% of available market capitalization.

S&P MidCap 400® Index
The S&P MidCap 400® Index provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500®, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.

Footnotes

1. Based on daily total net return data as of August 23, 2024.
2. Two seats had not been declared at the time of writing.
3. We selected this starting point for our analysis to have an adequately large sample size of managers for all strategies evaluated. Emerging markets managers offered a particularly thin data set until reaching 200 managers in 2011.
4. See David Ikenberry, Richard Shockley, and Kent Womack, “Why Active Fund Managers Often Underperform the S&P 500: The Impact of Size and Skewness,” The Journal of Wealth Management, January 1998.
5. See Antti Petajisto, “Underperformance of Concentrated Stock Positions,” https://ssrn.com/abstract=4541122, June 30, 2023.
6. Style drift is a natural tendency for managers that appears to have more to do with changes in the opportunity set than intentional shifting of strategies. This is reflected in the apparent correlation between value and growth managers’ style signatures.
7. See Alex Chinco and Marco Sammon, “The Passive Ownership Share is Double What You Think It Is,” May 19, 2023 (last revised April 7, 2024).
8. The authors acknowledge they may be underestimating passive investing, given their research focused on five index funds: S&P 500, S&P MidCap 400®, Russell 1000®, Russell 2000®, and Nasdaq 100 indexes. However, the vast majority of index fund assets track market-cap weighted indexes that are concentrated in the largest stocks (e.g., S&P 500, Russell 1000®, and Russell 3000®indexes).
9. While the term 130/30 is frequently used to describe such managers due to its popularity, the industry uses this term to refer to any long/short exposure that nets to 100%, such as 120/20 or 150/50.

The post VantagePoint: Building Resilient Public Equity Portfolios appeared first on Cambridge Associates.

Many financial publications have recently argued that US small-cap stocks will struggle until the Federal Reserve starts easing. They typically noted that 1) small-cap companies are more levered than large caps, 2) small-cap companies have more floating rate debt and thus suffer more from Fed tightening, and 3) many small-cap companies are unprofitable, further compounding these issues.

This narrative has some element of truth to it, especially when discussed in the context of the Russell 2000® Index. Around 40% of Russell 2000® companies don’t have positive earnings, are more levered than large-cap equivalents, and around half of their debt is floating rate.

However, these arguments are less applicable to quality small-cap companies, which can be proxied with the S&P SmallCap 600® Index. Around 80% of S&P 600 companies were profitable in 2023, compared to around 60% for the Russell 2000® Index. S&P 600 companies do have more leverage than large-cap peers, but neither absolute levels of debt nor recent trends are concerning. The median S&P 600 (non-financial) company had debt-to-EBITDA of 2.4x at the end of 2023, basically unchanged from 2019 (pre-pandemic) levels. Furthermore, despite suggestions that Fed hikes are increasing interest expenses and weakening debt servicing ability, the median interest coverage ratio for an S&P 600 (non-financial) company, 7.5x, remains similar to 2019 levels. For context, this is well above the typical coverage level of a high-yield borrower of around 5x. The “tails” or weakest links have also held up. The interest coverage ratio of the lowest decile (10th percentile) S&P 600 borrower was 2.6x at the end of 2023, down slightly from the year before but almost identical to 2019 levels.

The simple explanation for this is that growth in cash flow of US small-cap companies has outpaced that of their interest expense, as these companies have benefited from strong domestic economic growth in the United States in recent years (roughly 90% of small-cap revenue is domestic). There is also a more subtle dynamic that reduces the macro threat of higher rates to small-cap investors. A significant portion of the leverage in the small-cap index is concentrated, with about 50% of the total debt of the S&P 600 held by around 10% of the companies. In most cases, these firms also have the cash flow to service their debt.

While leverage fears have been overstated, earnings growth has, indeed, been weak. S&P SmallCap 600® Index earnings dropped around 30% in 2023 and are only expected to rebound around 8% in 2024. Sectors like healthcare and retailers are struggling with margin pressures, given tight labor markets, and a high index weight for the struggling REIT industry does not help either. That said, there are some nuances the market may be overlooking. One is that the earnings drop in 2023 was from a very high level—in fact, index earnings more than doubled between 2019 and 2022. Another is that as contracts for some companies are being reset and margins restored, expectations for 2025 look encouraging. The S&P SmallCap 600® Index is expected to grow earnings almost 20%.

Persistent inflationary pressures mean expected Fed rate cuts have been pushed back by the market, and the perception that lower rates are required for small caps to outperform could continue to hang over the asset class. In the meantime, the 14x forward price-earnings ratio for small caps reflects a historically wide 30% discount to large caps and is not justified by balance sheets or operating fundamentals. As the market eventually shifts its focus to long-term earnings potential, small caps are poised to shine.

Wade O’Brien, Managing Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.
2. Two seats had not been declared at the time of writing.
3. We selected this starting point for our analysis to have an adequately large sample size of managers for all strategies evaluated. Emerging markets managers offered a particularly thin data set until reaching 200 managers in 2011.
4. See David Ikenberry, Richard Shockley, and Kent Womack, “Why Active Fund Managers Often Underperform the S&P 500: The Impact of Size and Skewness,” The Journal of Wealth Management, January 1998.
5. See Antti Petajisto, “Underperformance of Concentrated Stock Positions,” https://ssrn.com/abstract=4541122, June 30, 2023.
6. Style drift is a natural tendency for managers that appears to have more to do with changes in the opportunity set than intentional shifting of strategies. This is reflected in the apparent correlation between value and growth managers’ style signatures.
7. See Alex Chinco and Marco Sammon, “The Passive Ownership Share is Double What You Think It Is,” May 19, 2023 (last revised April 7, 2024).
8. The authors acknowledge they may be underestimating passive investing, given their research focused on five index funds: S&P 500, S&P MidCap 400®, Russell 1000®, Russell 2000®, and Nasdaq 100 indexes. However, the vast majority of index fund assets track market-cap weighted indexes that are concentrated in the largest stocks (e.g., S&P 500, Russell 1000®, and Russell 3000®indexes).
9. While the term 130/30 is frequently used to describe such managers due to its popularity, the industry uses this term to refer to any long/short exposure that nets to 100%, such as 120/20 or 150/50.

The post Are US Small Caps Poised to Outperform? appeared first on Cambridge Associates.