Why Active Management Underperformed In 2014

Mar 19 2015 | 6:32am ET

By Alexander J. Hart, CFA
Director, Equity and Fixed Income Research
Federal Street Advisors

For the U.S. stock market, 2014 was another banner year. The headline S&P 500 index hit new all-time highs, corporate profits grew, economic growth strengthened and unemployment levels continued to fall. The S&P 500 Index returned nearly 14%, posting its fifth double digit return in the last 6 years. However as the year came to a close, many investors found their portfolios lagging these strong index returns. This was particularly true for investors using actively managed strategies. 2014 was one of the worst years on record for active managers. The passively managed Vanguard 500 Index fund return was in the top quartile of all large cap strategies, beating 80% of all funds tracking that benchmark. In the past 20 calendar years, this index has finished in the top quartile only 5 times. The first three times came during a rapidly appreciating market as the dot-com bubble formed, 1995, 1997, and 1998. And more recently the index did it again in 2011 and 2014. While we think these two periods are certainly different in terms of market conditions, there are lessons of patience to be learned from both, as this strong index performance can be deceiving, not truly reflecting the fundamental factors that drive long term wealth creation.

While the strong S&P 500 index return might indicate broad strength in the stock market, when we dissect 2014 in more detail we find a number of market challenges that caused active manager underperformance. The first comes from the large dispersion of returns between small and large capitalization stocks. U.S. large cap stocks were the strongest performing equity asset class in 2014. In contrast, small cap stocks, as measured by the Russell 2000 Index, returned just 4.9% and spent most of the year in negative territory. Many active managers find mid-cap and small cap stocks to be more fertile stock picking grounds. As companies grow in size and mature, their growth rates typically slow and earnings become more consistent and predictable as the businesses are diversified. Many active managers add value by taking a view that earnings will be different from consensus Wall Street estimates, which naturally draws them to areas where outcomes are more varied. The average large cap manager held about a 20% weighting to mid-cap and small-cap stocks during the year. This allocation detracted from returns even in the face of good stock selection as these asset classes widely underperformed.

While the U.S. economy strengthened in 2014, much of the rest of the world faced economic slowdown presenting another challenge to active managers who ventured outside of U.S. domiciled companies. As globalization continues to take hold, companies are not only expanding operations and supply chains across borders, but are also forced to compete for customers within their respective global industries. Naturally the winners and losers of this global competition will no longer be a function of the company’s country of domicile, and as such many U.S. focused active stock managers have sought to invest in the stocks of companies outside of the U.S. The dichotomy of the strengthening U.S economy and weakening growth globally pushed the US dollar higher relative to other major currencies in 2014. As a result, the returns of stocks not listed in U.S. dollars suffered considerably. The MSCI EAFE Index which tracks the performance of developed Non-US stocks lost 10.8% of return due to currency translation alone. The S&P 500 is 100% domestic so any exposure active managers had to Non-US stocks detracted from relative returns. These currency moves are often sharp and driven by investor speculation rather than fundamentals. Interestingly, despite the recent underperformance, the international companies held by active managers may be poised to reap longer term benefits of these currency moves as their exports become cheaper to consumers and provide a boost to their earnings in coming quarters.

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