“Owning the stock market over the long term is a winner's game, but attempting to beat the market is a loser's game”. John Bogle
Supporters of active fund management claim the real value of such an approach becomes apparent in times of market downturns. While passive managers track a falling index, their active peers can deviate to outperform the market, providing downside protection. Following this argument, 2020 should have been a good year for active managers.
The debate as to whether active or index funds provide superior returns to investors is not new, having raged since 1975 when the first passive fund was introduced. Prior to this, active management reigned supreme. Investors had no option but to place their faith in the abilities of active fund managers. Active strategies may have become more complicated but essentially, they remain the same; identify undervalued securities, forecast market growth and economic trends. We cannot say active managers never outperform the benchmark but their ability to consistently outperform is rare and it’s even more difficult to predict which manager will do so.
Passive managers on the other hand attempt to mimic the returns of the benchmark by purchasing all, or most of its holdings and then doing, well, nothing. The key advantages: lower costs while capturing market performance. A passive strategy does not require huge teams of analysts nor frequent trading, which create costs that compound and act to erode returns over the long-term.
The pandemic has provided active managers with a prime opportunity to prove they can deliver in times of market stress. However, research by Morningstar found that in the first six months of 2020 only 51% of active funds both survived and outperformed their average passive peer. Researchers from the Booth School of Business reached a similar conclusion following a review of US equity funds during the pandemic, finding that most active funds underperformed passive benchmarks.
A six-month time frame is too short to represent any meaningful relationship and an active manager’s ability to outperform should be taken in the context of entire market cycles. However, again, the data fails to provide evidence of the ability to consistently outperform in bear markets and bull markets.
As more investors become aware of the benefits of passive investing, active managers are coming under even more scrutiny. Indeed, M&G, a goliath of the fund management industry, recently admitted that performance of three of its active funds provided poor value to investors. No wonder the trend of investors moving their assets from active to passive managers continues. It appears that investors are increasingly learning the value of doing nothing, however counterintuitive. Maybe it’s time for M&G and other active managers to learn the value of doing nothing too?
Quarterly returns for all portfolios have been positive, continuing the recovery first seen in quarter 2. Portfolio 1 and Portfolio 2 continue to remain in negative territory over 1-year. However, their position has much improved since the end of the last quarter. Portfolio 2 had a 1-year return of -6.1% to the end of June, which has pulled back to -1.8% by the end of September. Similarly, Portfolio 3 has pulled back from -11.1% to -4.1%. Taking a longer-term perspective, the returns over 5, and 7 years are also positive across all models.
Portfolio 3 has fallen the most in the 1-year period due to the high exposure to equity, whereas the other portfolios both include a more substantial allocation to fixed income, a defensive asset, which has acted to protect investors during the recent downturn. The unprecedented fall in equity markets earlier in the year has also resulted in Portfolio 3’s 9.7% cumulative return over the 3-year period lagging the other portfolios. However, over the longer-term period, the equity focussed portfolio delivers the highest returns.
2020 has been a rollercoaster for investors. The first quarter saw the fastest 30% drawdown in the history of global equities, the next quarter saw the largest 50-day advance since records began and quarter three continued to build on this recovery seeing a 3.8% increase in global equities. The initial recovery was driven by unprecedented levels of financial support by central banks and governments. With the virus apparently subdued lockdowns eased and economies continued to recover in quarter three.
The US economy continues to rebound, x. US equity markets are following suit with 4% growth over the last quarter. Investors may worry that a victory for the Democrat candidate in the fast approaching US election will curtail this continuing rebound.
However, research suggests there is no significant link between a President’s political leaning and investors’ returns. A more valid concern could be the prospect of a prolonged period of uncertainty if Biden does win the election and Trump fails to concede and instead pursues legal avenues to remain in power. This could leave the US in a state of limbo for months.
UK equity returns continue to lag their European counterparts. The reason? The continuing Brexit saga. Despite four years of political pantomime and negotiations a deal still seems elusive. Recent developments do not bode well for a swift reversal in fortune given the UK government’s decision to unilaterally amend the EU Withdrawal Agreement. If an agreement is not met, the UK will leave the European Union at the end of the year and conduct trade based upon WTO terms.
Despite the recent flurry of activity and the threat of a “no deal”, the impact on the UK equity market and exchange rates has been minimal. The UK equity market has yet to recover fully from the initial decrease in value from the fallout of the vote in 2016. This can be seen in the chart below whereby the FTSE All Share continues to lag both the Euro Stoxx 50 and S&P 500.
This illustrates the importance of maintaining a global approach to investing and not pursuing a UK home bias, as comfortable as such a strategy may appear.
Emerging markets were also hit hard initially by the virus but continue to recover. China, which makes up 41% of our emerging market proxy, continues to grow. However, it does so against a backdrop of escalating tensions with the West. The introduction of a controversial National Security Law which curtailed protests and free speech in Hong Kong in June was met with dismay from Western governments, in the same month a spate of cyber-attacks on Australian businesses and government agencies were attributed to China. In July, the UK government set out plans to remove Huawei from its 5G network and most recently the US warned of the threats to national security posed by the Chinese owned apps TikTok and WeChat.
The China-US trade war continues. At the start of the year a “phase one” deal was agreed, by which China agreed to purchase at least $200bn more of US goods and services over the next two years compared to 2017. This looked like the beginning of the end for the trade war but six months on, China, battered by the coronavirus has failed to meet its obligations. With a deteriorating political relationship, preventing a full-blown trade war may be difficult. This would serve only to hurt both economies.
Our global property fund has had another quarter of subdued growth, this is to be expected as indirect property holdings such as REITs tend to fall more quickly and deeply during a downturn and lag the equity market in recovery. Given this, you may wonder why our portfolios contain indirect as opposed to direct property funds. Would the latter not be a better option?
Investors in physical property funds have had a stressful few years with repeated suspensions. These funds typically invest in physical commercial property. Problems arise when investors demand large amounts of their investments back and the fund manager is unable to satisfy these requests without liquidating holdings. This results in the fund manager suspending the ability to sell fund units.
Before the year began, back in December 2019, M&G’s Property fund was suspended after experiencing unusually high outflows against a backdrop of continuing Brexit uncertainty and concerns of a structural shift in the retail sector. The fund has remained closed to this day, trapping £2.1bn of investors assets. A few months later, the pandemic provided the catalyst to close all the UK’s major property funds, trapping an estimated £22bn.
Direct property funds can act as a useful asset class for diversification purposes, but investors need to have a long-term horizon and the ability to take on liquidity risk. Because of the issues related to physical property funds, our portfolios invest passively in property via Real Estate Investment Trusts.
As the third quarter of 2020 ends, the economic outlook remains as it has since the pandemic began: uncertain. The unseen virus continues to interfere in the lives of us all, both financially, mentally and physically. Lockdowns may serve to reduce infection rates but come at a heavy price. Ultimately a vaccine must be found, and although tremendous progress has been made to this end, realistically it will not be available until next year.
Rest assured, you have one less thing to worry about as your investment portfolio has been designed using decades of research so it has the greatest chance of weathering, what can appear to be the never ending COVID 19 storm.
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2. CityWire. (2020, July 2). M&G launches major fee review and admits Recovery fund is poor value. Retrieved from https://citywire.co.uk/new-model-adviser/news/mandg-launches-major-fee-review-and-admits-recovery-fund-is-poor-value/a1375598
3. European Centre for Disease Prevention and Control. (2020). COVID Situation Dashboard. Retrieved from https://qap.ecdc.europa.eu/public/extensions/COVID-19/COVID-19.html#global-overview-tab
4. Financial Times. (2020, July 25). Passive Funds batter active products during 2020 “wild ride”. Retrieved from Financial Times: https://www.ft.com/content/c64871d8-08cb-40cc-a87c-15b3b555a663
5. Financial Times. (2020, September 19). Property funds stay shut amid fears of liquidity crunch. Retrieved from https://www.ft.com/content/91450936-80bb-4ef2-9997-9ed2be767212
6. M&G. (2020, September 8). M&G Property Portfolio — Important information on the suspension of dealings. Retrieved from https://www.mandg.co.uk/investor/articles/property-portfolio-temporary-suspension/
7. Morningstar. (2020). Busting the Myth That Active Funds Do Better in Bear Markets. Retrieved from https://www.morningstar.com/articles/999669/busting-the-myth-that-active-funds-do-better-in-bear-markets
8. Pastor, L., & Vorsatz, B. (2020, August 12). Mutual Fund Performance and Flows During the COVID-19 Crisis. Chicago Booth Research Paper No. 20-18. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3648302
9. Reuters. (2020, June 19). Australia sees China as main suspect in state-based cyberattacks, sources say. Retrieved from https://www.reuters.com/article/us-australia-cyber/australia-sees-china-as-main-suspect-in-state-based-cyberattacks-sources-say-idUSKBN23P3T5
10. Vanguard. (2019, January 18). Are you ready for a bear market? Retrieved from Vanguard: https://www.vanguard.co.uk/adviser/adv/articles/research-commentary/portfolio-construction/ready-for-bear-market.jsp
11. Vanguard. (2020, September 7). What the US elections mean for investors. Retrieved from Vanguard: https://www.vanguardinvestor.co.uk/articles/latest-thoughts/markets-economy/what-the-us-elections-mean-for-investors