Mr Burge: Do you know Lord Astor has made a statement to the police saying that these allegations of yours are absolutely untrue?
Mandy Rice-Davies: He would, wouldn’t he?
At the trial of Stephen Ward, 29 June 1963, in The Guardian 1 July 1963
Like the unfortunate viscount, there’s a certain predictability to the advocates of active management, in which favorable news is routinely touted as evidence of active management’s ability to add value. Yesterday brought an example in a Merrill Lynch report indicating that 44% of U.S. equity managers had outperformed their benchmarks so far in 2015.
One obvious, and immediate, reaction is to note that if 44% outperformed, 56% must have underperformed. That degree of underperformance is quite consistent with the historical record for large-cap U.S. managers. And it’s also fair to point out that what the first five months of 2015 gave, the next seven months can take away.
What’s more interesting is Merrill’s observation that “Value managers had the highest hit rate of 77%, while 36% of Growth and 29% of Core managers beat their benchmarks.” Why were value managers so much more successful than their non-value competitors? The answer may be that, in the early months of 2015, value was relatively easy to beat. The S&P 500 Value Index, e.g., was up only 1.55% through the end of May, vs. a total return of 3.23% for the S&P 500 itself and 4.80% for the S&P 500 Growth Index. This suggests that the success of value managers is due not to their stock selection within the value universe, but rather to their ability to tilt away from value and toward growth.
Of course, there’s nothing wrong with a value manager’s tilting toward growth — assuming that his clients’ guidelines permit it, and assuming that he’ll know when to tilt back toward value. In general, an active manager can add value by either stock selection or sector allocation, and there’s no insurmountable reason to prefer one technique to the other. There are more potential opportunities in stock selection, of course (500 stocks vs. 10 sectors), but a manager who’s consistently good at allocation among sectors can be an excellent manager.
Asset owners may well be indifferent between receiving selection alpha and receiving allocation alpha. But they should understand the source of their managers’ value added. And they should realize that allocation alpha can be fleeting. If value starts to outperform growth, the allocation shoe will be on the other foot.