The market rally offers tough lessons for fund managers

Oh, poor fund managers. Why the long faces?

July was awesome! The S&P 500 had its best performance since late 2020, up 9 percent. It was one of the best months on the market ever. Sure, the generous withdrawal by the world’s most important central banks introduces a new wave of volatility in asset prices, but this has to be the bounce we’ve all been waiting for, right?

apparently not. Instead, this appears to be another pain trade. Bank of America notes that despite a significant rally in the past month, only 28 percent of active fund managers focused on large stocks beat the Russell 1000 benchmarks. All of the major patterns of underperforming mutual funds — core, growth, and value.

Kudos to the minority, but how did others manage that? All year long, investors have been desperate to break the clouds, and a little hint of indulgence has finally emerged from the Federal Reserve, and they are still far behind their benchmarks. It appears that a lot of money was tied up in a safe hidden pit of cash, and very little was used to rise.

The bearish situation “is likely to affect performance,” Bank of America analyst Savita Subramanian and colleagues said in a note to clients. She added that opportunities to beat the market are still scarce, making this a “challenging environment” for funds that choose stocks rather than relying on indexes.

One explanation for this is that professional investors are not fools. This hint of indulgence from the world’s most powerful central bank was over-interpreted and came with far more caveats than the initial market reaction suggested.

Every Fed Chair Jay Powell has said that it is likely, but not certainly, appropriate to slow the pace of interest rate hikes in the future. Some market participants took it as a signal to step up bets on interest rate cuts and a return to stocks that suffered while the Fed was talking hard about inflation. This week, a series of Federal Reserve speakers asked the markets to de-escalate the crisis. They said they are not close to a pivotal point yet and expectations for a rate cut next year are premature.

S&P 500 Vertical Chart, Monthly Percentage Change Shows Can US Stocks Continue Rally After Best Month Since 2020?

Another way to think about this is to ask who made the purchase. Much of it appears to have come from funds that have been very bearish, with a lot of shorts – or bets against stocks – on their books. Hedge funds and momentum chasers such as commodity trading advisors – CTAs – have backed well off risky assets and then scrambled to catch up when stocks rallied, a practice known as short-covering.

Stocks are bouncing . . . Barclays analysts wrote: “Best-selling stocks have already outperformed in Europe and the United States.”

An equal-weight basket of the 50 most shorted stocks at Russell 3000,” led by the most speculative. . . Nonprofits “are up about 31 per cent since June, with catching up now in Europe,” says Neil Campling, equity analyst at Mirabud.

Anik Sen, Head of Equities at PineBridge Investments, is what you call a bottom-up investor, building portfolios that focus on a relatively small number of stocks – from 30 to 40. His job is to pick out the good stocks and neutralize the impact of broader moves in the indices. This task, he says, is further complicated by the large role that equity flows from macro funds and from CTAs play.

“I’ve been doing this for over 35 years, almost 40 years. The disconnect between bottom-up and top-down is probably the widest I’ve seen,” he says. “The markets are not moved by you and me but by the macro traders . . .[Their flows]Dwarf these are core investors.”

This cuts both directions. Sen sees the July rally as “sustainable” and that the markets have been very bleak for most of this year. He thinks some company stories are much stronger than what investors give them credit for. “We cannot understand why the markets are so negative,” he says, adding that the war in Ukraine, inflation, the supply chain and the Covid lockdown in China have masked otherwise positive factors.

But the muted performance of mutual funds in July highlights the extent to which broad shifts in asset allocation linked to strong macroeconomic trends are leading to rail equity specialists.

My feeling from talking to the fund managers is that this has become very frustrating. They made the mistake of being too positive at the start of the year and then missed a stunt in July. Perhaps the best approach now would be to be somewhat philosophical.

“You can easily get stuck in short-range motions,” said Mamdouh Medhat, a senior researcher at Dimension Fund Advisors, a house of quantum founded in the 1980s. “It’s like a game of ping-pong and commenting on every stroke of the ball.”

As boring as it sounds, sticking with the markets for the long term is always still the best tactic. “It is very difficult to beat the market by trying to outpace it. Sometimes people make the right calls out of pure luck,” says Medhat with a calm tone of therapist. “Be conservative. . . If you are widely diversified, you get the only free lunch in finance.

katie.martin@ft.com