Indexology^® Blog

Tomorrow the Federal Reserve is expected to raise its benchmark Federal Funds rate by 25 basis points  — the first increase in seven years.   This increase, assuming that it comes, must surely rank among the Fed’s most advertised and anticipated moves ever, and Wall Street trading desks are ramping up in expectation of heightened trading volumes.   We have no special insight into the immediate or longer-term aftermath of the Fed’s decision — but we would caution that, for equity investors, there are at least three things that rising interest rates will not do.

First, they won’t tell us whether the stock market is going up or down.  There are good theoretical arguments to support the view that rising rates are bad for stocks.  If dividends are discounted at a higher rate, stock prices should come down, other things equal.  The problem is that other things may not be equal.  If rate increases come in response to a strengthening economy, they may be associated with rising stock prices.   In recent years, in fact, the U.S. equity market has been stronger when interest rates rose than when they fell.

Second, rising rates won’t cause stock market dispersion to increase.  Dispersion indicates by how much the best performing stocks in the market are beating the underperformers.  In a high-dispersion environment, a manager’s stock selection skill is worth more; if dispersion is low, his skill is less valuable.  Dispersion has been well below average for the past several years, which has contributed to the performance difficulties of most active managers.  But there’s no reliable evidence to suggest that an increase in interest rates will drive dispersion upward.  Whatever difficulties stock selection strategies faced with the Fed Funds rate at zero are likely to persist at 25 basis points.

Finally, rising rates won’t help us identify outperforming equity factors.  Rising rates don’t give us a reliable guide to the relative performance of growth vs. value, say, or of low volatility vs. high beta.  Through the first 11 months of the year, growth is well ahead of value, and low volatility well ahead of high beta.  Whether those trends continue or reverse is unlikely to depend on what the Fed does tomorrow.

Energy has been the hot topic in regard to investments.  The drop in the price of oil (USD 37 per barrel) and prolonged low values of many commodities (S&P GSCI, -33% YTD) has added concern to an already nervous bond market.  The expectation that the U.S. Federal Reserve would follow through on its assumed intention to start raising rates after its Dec. 15–16, 2015, round of meetings already had market participants on edge.  Current events in the bond and commodity markets have added a heightened sense of unease.

In this market environment, interest in energy has taken on a life of its own.  The Materials sector can also be included in the concern group as the sector is highly related to commodities such as chemicals, metal & mining and construction materials.  As a point of information and comparison, Exhibit 1 gives insights into a few of our key indices.

Exhibit-1: Index Industry Weights

As 2015 inches closer to the final bell U.S. municipal bonds are leading the returns as we near the halfway point of the final lap.

As of December 14th, 2015….

The S&P Municipal Bond Investment Grade Index has recorded a total return of 3.09%.  Key factors for the muni market in 2016 include:

• Real new issue supply excluding refunding bonds could grow in 2016.  This would be a welcomed sign for the muni market but will test the demand side of the equation.
• Demand for better quality municipal bonds has been strong and could remain strong in 2016.
• Defaults in the municipal segment are few but make powerful headlines.  Puerto Rico remains the largest drag on the overall muni market.  These events should support the higher grade portion of this market.

The S&P Municipal Bond High Yield Index has also shown positive returns of 2.51%.  Key factors for the junk muni bond market in 2016 include:

• Puerto Rico resolution or steps toward resolution.
• Low real new issue supply of higher yielding municipal bonds helps keep the imbalance between demand for yield and supply off kilter.

U.S. Corporate bonds tracked in the S&P 500 Investment Grade Corporate Bond Index have just about returned 0% and the S&P 500 High Yield Corporate Bond Index has returned -4.68% so far in 2015.  The market for these bonds in 2016 may be affected by:

• Expected lower new issue supply of investment grade bonds.
• A decline in the energy bond and mining related debt markets.
• Rising rates impacting the yield curve: i.e. flattening or steepening the curve.  Expectations are that flattening is more likely.
• Credit spreads widening in the junk sectors.

Table 1:  Select Fixed Income Indices Yields and Total Returns

Table 2: S&P 500 and S&P GSCI Total Returns

The concentration of bonds trading in the secondary market rises the weaker the credit quality of bonds.

The distressed segment of the junk bond market has the most concentrated trading activity indicating that the majority of bonds in that segment are significantly less liquid.

The top 20% of bonds in the S&P U.S. Distressed High Yield Corporate Bond Index in November represented:

• 86% of the total number of trades that occurred in that quality segment.
• 75% of the total market value of trades that occurred in that quality segment.

For comparison, trade data for other quality based indices is in the table below.

Table 1: Select Indices and Corresponding Trade Volume Statistics on the Bonds In Those Indices (Month of November 2015).

With the release of the latest SPIVA® Cross-Country Comparison results, the debate between active and passive investment management has once again ignited.  Proponents of passive management point to the SPIVA data as evidence of the inability (in aggregate) of asset managers worldwide to beat relevant passive indices over meaningful periods of time.  Meanwhile, proponents of active management suggest weaknesses in the passive approach, including the potential for active management to protect “on the downside” relative to index-weighted portfolios.

There are real dollars riding on winning the active versus passive argument.  Every time the debate re-emerges, battlelines are drawn and positions are defended vigorously around one question: is it possible to outperform on a risk-adjusted basis (generate “alpha”) consistently over an extended period of time?

Alpha is the part of a security’s return that remains after accounting for all known embedded risk factors.  Why is it seen as the pinnacle of investing?  Because in a world where we are told there are “no free lunches,” alpha is just that; a return component above that required for bearing all known risks, and thus attributed to investment skill.

In a competitive market where everyone has access to the same information and acts on it with equal speed, alpha can indeed be a sign of skill.  It could just as easily be a product of luck.  Over short periods of time, investment skill is indistinguishable from luck.  The longer a fund manager consistently delivers alpha, the more probable it is that skill rather than luck explains the alpha.

The case for passive investing is often held to rest on the Efficient Market Hypothesis (EMH).  It suggests that in a market that is efficient, all relevant information is already incorporated into each security’s current price, and any new information will be incorporated too fast to consistently act on and profit from.

While some proponents of active management view EMH adherents as nay-sayers lost in the axioms of their own theoretical world, the disdain is not reciprocated.  EMH is a vindication of the competitive spirit of capital markets, not a criticism of it.  Alpha is hard to find precisely because there are so many highly intelligent and extremely motivated people looking for it.

In 1979, according to the Investment Company Institute, there were some 530 mutual funds in the U.S.  By 2013, this number had increased 14 fold to exceed 7,500 funds.  Asset management has been a favored destination for MBA graduates the world over for at least the past two decades.  They, along with CFA charter holders and those with doctorates in physics and applied mathematics, compete for entry into the lucrative world of asset management.

Yet, armed with all this prodigious human talent together with the fastest computational technology, alpha has become harder to consistently generate.  Why?

The answer may lie in the “paradox of skill,” a phenomenon that has been observed in competitive arenas such as professional sports.  The crux of this paradox is that as time passes and competition intensifies, the skill level of the average participant increases.  Importantly however, the spread of skill, from the most talented to the least, reduces with time.  In an environment where the absolute skill level is rising while the relative skill level is in decline, luck starts to play a larger role in outcomes.

Take baseball.  Why has no player in Major League Baseball had a batting average over .400 since Theodore “Ted” Williams of the Boston Red Sox hit .406 in the 1941 season, despite pros becoming far better conditioned over the intervening 70+ years?

In a similar fashion, the batting average of legendary Australian batsman Sir Donald Bradman of 99.94 runs (from 1928-29 to 1948) has never been matched in the modern era, where an average above 50 is rare.

Both Williams and Bradman were superb athletes of their day, yet it is unlikely that they would have been able to replicate their stats against the average opponent of the modern era.

The dawn of professional sport heralded a revolution in training, diet, physical and mental conditioning, and data analytics.  The result is an overall skill level in elite sports today incomparably higher than the past, yet without the most skilled players able to dominate as they could in previous eras.

A similar force is at work in professional investment management.  The average fund manager today is the financial equivalent of a professional athlete, with every advantage that a high IQ, elite education, and rigorous training can bestow, and yet despite all these attributes, the SPIVA results are unequivocal.  The ability to beat the market on a risk-adjusted basis consistently over time, especially after fees and taxes, isn’t getting any easier.

Blame it on the paradox of skill.