What has been the impetus for a host of active mutual fund outperformance against the S&P 500 benchmark in early 2017? Exposure to the Information Technology sector, a May 26 Goldman Sachs report observes. But with this recent outperformance in the rear view mirror, fund managers are reducing exposure to the sector that delivered the mutual fund outperformance, bringing their exposure closer to beta.
Mutual fund outperformance: IT sector making fund managers look brilliant, but they back away from exposure
Lately, it might seem like rooting for hedge funds to outperform their benchmarks was rather an experience like rooting for the Chicago Cubs. The baseball team of celebrated “losers” until recently had not won a world championship since 1908 – a point in history when general manager Theo Epstein noted in a recent Yale commencement speech, the Ottoman Empire still existed.
Waiting for active fund managers to generally beat their benchmarks had a similar feeling, particularly if we simply transpose 1908 for 2008.
But that started to change in 2017, David Kostin, Goldman’s chief US equity strategist, noted in the firm’s US Weekly Kickstart portfolio strategy review. While Kostin has the look of a Yankees fan, he and his research team note rare mutual fund outperformance, were 50% of funds are beating their stock benchmarks year-to-date.
Part of the causation for this move is the Information Technology sector, which funds are 2.29% overweight. The IT sector has more than doubled the already strong performance of its index benchmark, up 20% vs. 9% for the S&P 500.
What is frustrating is that, just like the Chicago Cubs in the days of old, nothing gets in the way of success more than the decisions the managers make.
Mutual fund managers have pulled back their over-exposure to the Information Technology sector which makes their performance model “closer to benchmark weight, reducing the potential for future alpha,” Goldman observed. The Kickstart report comes as the investment bank published its quarterly Mutual Fundamentals report, which analyzes the performance and positioning of 355 mutual funds with .3 trillion in assets based on the latest SEC filings.
But it’s not just absolute returns that made the IT space so pleasant to investor's palate. For those discerning allocators, the risk-reward has been tasty, with upside deviation playing a positive role in the IT sector’s 3.7 Sharpe Ratio year-to-date.
As Goldman notes:
Fund managers are now 32% overweight Information Technology + Internet & Catalog Retail (a Discretionary industry) (Chart 1). And this is driven by a remarkable 71% overweight in FANG stocks. But note that active managers’ relative weight in the FANG stocks has been relatively flat for nearly a year, so the recent move in FANG may be driven more by short-covering than by active buying.
Paul Singer noted the FANG danger in his recent letter to investors.
But IT isn’t the only sector that has been delivering strong risk-adjusted returns year to date in the wake of the lowest volatility in the first 100 trading days since intra-day trading records began in 1970, according to LPL Financial.
Sector winners tout upside deviation while losers lick wounds
Outside of technology, other sectors have experienced an auspicious start to 2017. This includes Emerging Markets, High Yield Credit, and worldwide developed markets are strong along with Consumer Discretionary and Consumer Staples issues – all of which have been aided by upside deviation in their returns but penalized for it in the Sharpe Ratio formula. Nonetheless, all have notable Sharpe Ratios over 2.0 and are boasting double-digit returns on the year.
The MSCI Emerging Markets index is up 18% year to date and has posted an attractive risk/return profile with a 3.1 Sharpe Ratio. High Yield Credit, while up only 5% on the year, is nonetheless boasting a 3.0 Sharpe ratio.
The worst performing sector from last week was energy, down -1%. This is also one of the worst performers on the year, off -11% and with a Sharpe Ratio of -1.3, not only is the Energy sector negative but one of the strongest components of that index, Crude Oil, is down 13% as well, leading the charge.
Overall global stocks are outperforming domestic stocks, where forward-looking Price Earnings ratios are leading value investors across the Atlantic.
While the IT sector has been in a decided uptrend that started nearly one year ago, trend momentum appears to have faded for financials and real estate, led in large part by retail mall REITS and the retail apocalypse, no doubt.
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But when that uptrend ends for tech watch out as the chart below demonstrates.
By Mark Melin
