Understanding causes for relative performance is always a key concern, but its importance is magnified under times of stress. After all, if your portfolio is up 14% while the market is up 17%, you’re probably not crying about it. On the other hand, if the market is down -4% while your portfolio is down -7%, you might have some sharp words for your service providers. In our previous monthly article (Why is The Sky Blue: Attribution and Relative Performance), we discussed portfolio level analysis and we promise to get to investment manager level analysis in the next newsletter. Similarly, we spent a little bit of time in a recent blog-post highlighting some of the key stocks – the FANG positions – which were among the limited number of beneficiaries during a rough 2015. It occurs to us now that there was something missing from the FANG analysis as it applies to attribution: weighting and momentum.
As a reminder, the FANG stocks (Facebook, Amazon, Netflix, and Google) were among a select few positions that strongly rallied in 2015 while the majority of positions faltered. But so what? There are always going to be winners and losers. There are hundreds, sometimes thousands, of positions within a market index. In most time periods, there’s going to be some unforeseeable blowout strength from a random company in the middle of the index. Active managers can’t expect to always perfectly select the best 10 stocks in an index for their portfolio, just so long as, on average, their collective positions beat the index.
Recall the reason the FANG stocks were avoided (or underweighted) by active managers: their valuations were too high and that valuation has continued to accelerate during the year. In other words, the prices investors were willing to pay for current earnings was already high and getting higher – that’s momentum. So, the combined market capitalization (i.e. the number of available stocks multiplied by the high price per stock) was also very high. That’s the trick: the FANG stocks were large parts of the indices, which are weighted by market capitalization. In contrast, the active managers tend to more equally weight their selections or even underweight the stocks which have stretched their valuations. In other words, when an active manager makes equally weights to their stock selections, they are making an inherent bet not simply FOR their selections but AGAINST the largest positions in the index. In financial parlance, they are shorting a position simply by not holding it.