Do Active Managers outperform during market downturns? KIID Transparency, Commodity Correlation & Thematic ETFs.

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q and A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

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Do Active Managers outperform during market downturns when equity sells off?

The conventional wisdom is that during bear equity markets stock pickers will outperform by dodging the bad apples, however the evidence from Standard and Poor's Index Versus Active (SPIVA) report does not bear that out: see for yourself here https://us.spindices.com/spiva/

In a document from 2008, when people were thinking about the credit crisis SPIVA says: 

“The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes...
However, one of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities. We dispelled this myth in 2003 using the case study of the 2000 to 2002 bear market. The downturn of 2008 provided another case study. The results are similar, with underperformance across all nine style boxes.”

https://us.spindices.com/documents/spiva/spiva-us-year-end-2008.pdf

Can you explain fund/trust costs as stated in the Ongoing Charges Figure (OCF) and the Key Investor Information Document (KIID) to enable understanding of why they can appear to differ and lack transparency?

By law in the UK every fund that exists has to produce a KIID and it has to be clear. If this is not the case, or the information about fees is not correct then the FCA will intervene.

This question is explained with two examples. Firstly, Harbourvest Global Private Equity (ISIN GG00BR30MJ80). 

This is a private equity investment company which will be higher risk than investing in an index but also has the potential for higher return. Usually the fees for this kind of investment are higher. The link to the Key Investor Information Document is visible at the bottom left of the screenshot above or here https://www.hvpe.com/~/media/files/h/hvgpe/reports-and-presentations/key-information-document/hvpe-key-information-document-2019-05-30.pdf

Often the more complex the product the more complex the pricing structure may become. Below is the table from the PIID that outlines the costs and you can see from this that fees are 1.5% ongoing but there is also an “incidental cost” if the performance is better than an 8% internal rate of return.

The second example is Scottish Mortgage Investment Trust’s fees. Their Key Investor Information Document is here https://documents.feprecisionplus.com/PRIIP/BAGI/PRP/BAIEPT_BE08_en-GB.pdf

They break down the ongoing costs of 0.77% as follows

  • The impact of the management fee payable to the Trust's investment manager (0.31%)
  • The Trust's other administrative expenses (0.06%)
  • The costs of borrowing money to invest, including interest and arrangement fees (0.38%) but not any income or capital benefit of doing so
  • The ongoing costs of any underlying investments in funds within the Trust's portfolio (0.02%)

Always look at the KIID documents as other sources can be more easily misread. For example if you look at the website from Baillie Gifford, where it talks about Scottish Mortgage, the table it uses presents ongoing charges  as 0.37% but with a very small footnote that goes on to say it will actually be more because of other costs.

https://www.bailliegifford.com/en/uk/individual-investors/funds/scottish-mortgage-investment-trust/key-information/

Which commodity ETFs are least correlated to equities during a recession?

If you look at the time series available most commodities’ data to which I have access only starts in 2000. This is not a  long enough time span to draw any sensible conclusions from as we have only had two recessions since then. However, we do have data for going back to 1965 for silver and for gold from 1920, but because it was linked to the gold standard, data is only really useful since the mid-1970s.

Overall the more  a commodity is used in manufacturing the it is more likely to be correlated to equities. This can be shown in the tables below that shows how correlated  gold, silver and the S&P 500 were during both recession and growth periods. You will see that the correlation of the S&P 500 compared to gold during a recession is 0.05,  but compared to silver, which has some industrial use, it is 0.137. Anything below 0.3 is considered very low correlation, so although silver has more correlation with the S&P 500 than gold, silver is still very low .


> round(recession.cor,3)

          spx       gold     silver

spx     1.000   0.050   0.137

gold    0.050  1.000    0.632

silver  0.137   0.632   1.000

> round(growth.cor,3)

          spx        gold      silver

spx     1.000   -0.040   0.033

gold   -0.040   1.000   0.601

Silver  0.033   0.601   1.000

Why are thematic ETFs cyclical?

We can turn this question around…

Imagine you are a fund manager. You can’t compete on fees with Vanguard and Blackrock and Fidelity so how can you make money? Thematic ETFs!

Thematic ETFs are one way of making income by charging more, but for people to want to buy them, they have to be:

  • Popular as a theme. 
  • Have a credible underlying thesis.  (i.e. some reasoning behind why it might make money)
  • Offer the potential for returns above the market if the theme pans out.

Although higher return usually means that there is a concentration risk in the theme’s sector, country or currency.

A high diversity thematic ETF would never make it past the drawing board as it would be very difficult to sell.  A low-risk ETF would also be unpopular and wouldn’t be able to offer above-market returns (and would run against cheap minimum volatility funds offered by the big beast fund managers). 

This means that in most cases in order to be sexy the funds have to be cyclical and higher risk than the broad market

If you look at  justETF https://www.justetf.com/uk/etf-lists.html extract below, you will see that 

Some of these might be a bit defensive

Ageing population” would include pharmaceutical companies which would be defensive

Socially responsible” would probably be neutral i.e. neither cyclical nor defensive

Volatility” would be defensive but that’s not really thematic it’s factor investing

Water” might be defensive because it probably contains lots of utility companies

But if you look at the others they will probably be cyclical as they would give you a higher risk with potentially a higher return. However, if the underlying thesis behind them fails to materialise then you have a high chance of losing money.

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October 14, 2019