A most painful rally

Most fund managers tend to prefer rising markets to falling markets, as the former tends to be better for the business in terms of more assets under management, higher fee revenues etc. However the market’s strong move up since early March has been at best a “mixed blessing”: most managers were positioned cautiously early in the year and remained so well into March and April, thus underperforming the index as markets rebounded. Most fund managers kept on expected lower levels of the markets well after the markets bottomed out.

The rally since March has been a painful one for many investors.

The performance track record of various funds in the current calendar year is illustrated below and reflects the fact that fund managers who pontificated holding cash as a strategy for outperformance have underperformed because of the same reasons thus reflecting the fact that cash with a large majority of them was a passive strategy rather than an active strategy. . A review of the monthly performance of 160 emerging markets mutual funds, for example,
illustrates this point:
In January, the average fund outperformed the S&P EM index by 147 basis points, and 78% of fund managers beat the index
In February
, outperformance continued, this time by 155bps, with 80% of beating the index
In March, this reversed dramatically
: now, the average fund underperformed the index by 546bps, and just 9% of fund managers beat the index
In April, funds continued to struggle against the index, although by less: the average fund underperformed by 247bps, and a larger minority (19%) beat the index
March was the truly extraordinary month: a terrific time for global equity markets (up 20.3%) but a terrible one for fund managers (up “just” 14.8%). This underperformance of 546 basis points, on average, was a record miss and will take considerable effort for some managers to recoup over the course of the rest of the year. It also explains why few in the global emerging market space were willing to continue to sit out rising markets as the rally continued into April and May. However in India most funds kept on sitting on record cash levels through the rally.

The trends are similar in India where over the period from the bottom of the markets on the 6th of March 2009 a vast majority of funds have underperformed the markets. As per data from valueresearchonline.com the average return of nearly 220 diversified equity funds till date has been 63% percentage vis a vis the NIFTY’s return of 65% percentage. Only around 35% percentage of funds have been able to outperform the NIFTY with the average return of the top 10 funds being 93% percent and the average for the bottom 10 being 37 percentage.

In the 12 month period till the 6th of March the NIFTY declined by 47% and the average fund declined by 49.5%.

Funds keep on flowing to Emerging Market Funds

When shares are rising, one certain way for a fund to underperform the index is by holding high cash balances; cash balances at EM funds and Indian Mutual funds reached multi-year highs in recent months.
However the problem in March was not only that starting cash balances were high, but that even more cash was coming in the door each day. Since the middle of March, emerging markets funds tracked by EPFR have seen $18.6b of cash inflows, a staggering amount and more than half of the total (record) outflows last year. At the current pace, all of the redemptions of 2008 will be replaced over the next few months, a remarkable reversal of fortune. In India although there have not been much inflows, the outflows also have been muted thus keeping the cash positions high.
Herein lies another mixed blessing. It’s hard to argue against more assets under management, however the historical pattern has been that very strong surges of buying tend to be associated with sharp corrections.
A similar story is told by another datapoint: the average premium or discount to NAV for closed-end emerging market funds. This also tends to be an indicator of exuberance towards the EM assets class, and not surprisingly late last year it had sunk to 10-year lows. This ratio has morphed from a large 15% discount late last year into a premium two weeks ago, indicating much improved sentiment.

Some closed-end funds have even seen their share prices reach a large premium to NAV in recent weeks – a phenomenon only seen in early 2006 before the big crash of May 2006.

Most investors have missed the rally — either by not buying soon enough or, for those who were fully invested in March , by having sold too early. The overall sentiment right now is that many of the defensively positioned funds who were holding out have “capitulated”, i.e. have cut cash and raised their exposure to the market.

This in my view increases the risk of a sharp and rapid correction in the markets over the next few weeks.

Leave a Reply

Your email address will not be published. Required fields are marked *