Tuesday, September 7, 2010

Six of Ten Largest Mutual Funds Currently Sport 0.99 Correlation with S&P 500

The immense correlation between the market, and almost all risk assets on Earth is not a new subject to FMMF readers.  [Jun 30, 2009: Bloomberg - Correlation Among Asset Classes Highest Ever]   I beat this dead horse monthly, mostly out of abject frustration.  [Sep 2, 2010: Why Bother with Individual Stocks in the Perfectly Correlated Market?]  I don't have an issue if the market is up 2-3%, that 90% of stocks move in the same direction - it is all these days the market is up or down 0.7% when it drives a person nuts.  Friday for example, every position I had but one was up - as I type this every position but one is down.

This correlation madness started to become an issue in 2007 as we were told that hedgies control 40%(ish) of each day's trading volume.  As I said then, since mutual and pension funds are relatively staid players, the 'fast money' is the marginal buyer.  And 'hot money' hedge funds - especially of the quant variety - are the marginal buyer.  The problem now is they seem to be the only buyer as equity fund withdrawals continue on pace as the retail guy floods into bond funds.  So we have a market dominated by computers trading to computers, all using related algo's - happy, happy, joy joy.  Now we hear things such as 60-70% of trades flow through these players.... and since EFTs are the weapon of choice, computerized trading of EFTs have taken over the market.  [Jun 29, 2010: Correlations Among Asset Classes Reach Ever Higher Extremes as HAL9000 Algos Dominate Life]    The SPY ETF is now about 9% of ALL volume as of last check, and we had a time about 7-8 months ago where Citigroup, AIG, Fannie, and Freddie were 40% of all volume.  Pathetic.

Frankly, it makes the market a frustrating and 'less fun' place - thoughts I am reading in many places on the internet.  The market used to be a 4 dimensional jigsaw puzzle, comprised of fundamental, technical, psychological, and 'animal spirits'.  Now it's just the dumbed down 2 dimensional Etch a Sketch.  Shake it at 4 pm every day, because it has no memory from day to day.  Sure you can adjust (in fact you must adjust) if you plan to stick around, but when everything is a 1:1 correlation, it simply reduces the market to 'stoopid' and coming in each day, checking your brain at the door, and staring at the S&P 500 chart trying to guess where it will be in 3 hours, 3 days, and 3 weeks gets to be boring. [Jul 15, 2010: WSJ - Correlation Soars on S&P 500 Shares]  But this is the casino market we have built, and I don't see anything changing anytime soon.   The other issue is it makes it so much more difficult to outperform the market.  Surely there are a handful of stock names that still outperform (or underperform) but with almost everything swaying in the exact same direction as the market, creating alpha is difficult.  Most of the performance nowadays is not about stocks, but due to calling turns in the greater market - increasingly hard to position for as you scale in size.  Especially when the majority of the turns are due to binary reactions to economic reports or Fed announcements - it's simply placing your bets on red and black, not a stock market.

I've written about said frustration in the past amongst the "human" hedgies, [July 8, 2010: Hedge Funds "Frozen in Headlights" as BiPolar Market with 1:1 Correlation in All Things Not Named U.S. Treasuries Causes Confusion]   and this is taking a toll on the mutual fund managers as well.  One of my big beefs with the mutual fund industry is many players - especially in the bigger funds - are closed index funds.  They all have super cool names but almost anything in 'large cap value' or 'large cap growth' were hybrid closet indexers. They basically flip an Exxon, Intel, or a Microsoft, with a Walmart, Verizon, or a Cisco Systems -- change the order, weighting, and indeed are able to charge a nice fee for doing nothing other than being the S&P 500 with a small twist.  I cannot tell you how many 401k plans I reviewed for people, where I went to look at the top 10 holdings of the 12-15 mutual fund choices and 90% of them were identical (just in different order in weightings!).  The statistic of 0.99 correlation amongst the S&P 500 and many of the largest funds is quite remarkable and points to my 'closet index' beef, but with the mechanics of our new paradigm market, it has taken it to a whole new level.   It also says a lot of people are wasting their money paying management fees for what is an S&P 500 ETF clone.

That said, even with the closet index situation that has been growing for a decade+ you used to be able to try to outperform if you plied your trade in small or medium caps (or international markets), but the HFT + EFT = GLEE environment we now live in has made that increasingly moot, since most of those stocks now move in unison as well.  If your stock is not in a major EFT it generally sits ignored with low volume... if it IS in an ETF than it doesnt matter the company specifics - as long as the algo's are buying (or selling that ETF) as flavor of the day, every component in that ETF is a winner (or loser)!  Stoopid is as stoopid does in the market with 1st grade logic.

One gentleman I've admired for many years is Will Danoff at Fidelity Contrafund (FCNTX).  [Sep 9, 2008: Will Danoff in Kiplinger Magazine]  His fund has been huge in size for years on end, (I'm talking multiples the size of the biggest hedge funds - Contrafund is now up to $62 BILLION), yet he has been able to somehow outperform his peer group (and until the past 5 years the S&P 500) by a wide margin, mostly by being somewhat contrarian.  This despite holding many positions and not being extremely concentrated - a feat I find quite remarkable since once you start owning 200-250 positions I don't know how you can beat the market over time. (Contrafund owns 445 positions as of last quarter!)  Danoff is highlighted in this piece, which is why I mention him - he is no dummy.

Via Bloomberg:

  • Fidelity Investments’ William Danoff, the stock picker who led the Contrafund to benchmark- beating returns, isn’t looking very contrarian these days.  Danoff’s $62 billion Contrafund, which seeks to beat the market by picking stocks whose value hasn’t been fully recognized, has tracked the Standard & Poor’s 500 Index more closely this year than in any year during its four-decade history.
  • “Danoff usually finds ways to go against the grain, but these days there isn’t much that’s contrarian relative to the macro theme,” Adviser Investments’ Lowell said. “This is a trendless market and it’s not providing him any room to break away from the S&P 500.”
  • Investing abroad hasn’t helped stock pickers like Danoff because correlation has shot up even between regions.
  • Danoff isn’t alone.   Six of the 10 largest U.S. stock funds show correlations of 0.99 this year, meaning they moved almost completely in sync with the market. Managers are struggling to stand out and attract new money as fear of another crisis prompts investors to move in and out of markets without discriminating between securities, industries or geographies. 
  • Robert Doll, BlackRock Inc.’s chief equity strategist, said while stocks moved in lockstep before, this is the longest he has seen correlation persist across markets.  “We were expecting 2010 to be the year when stock selection would add value, but that hasn’t been the case.”
  • Doll says even the most high-quality stocks have been hurt among a larger sell-off in risky assets.   “We’ve scratched our heads many times during this year as the macro picture is driving everything,” Doll said. “It can be frustrating along the way, but we’re just focusing on the fundamentals and eventually we’ll get paid for it.”
  • The correlation between the U.S. equity benchmark and its individual members was 0.81 in the 50 trading days through July 7 and has since remained close to that level.  That’s almost twice the historical average of 0.45 over the past 30 years.
  • The increase in correlation is making it difficult for actively managed funds to beat their benchmarks and produce better returns than lower-cost index products.    “You can’t pick any mutual fund, even if has previously been a winner, and expect it to outperform in this market.”
  • Mohamed El-Erian, the chief executive officer of Newport Beach, California-based Pacific Investment Management Co., says investors have a “risk-on/risk-off” attitude that leads to sometimes “violent” swings, such as the sell-off in markets worldwide on Aug. 11, after the Federal Reserve indicated that the economic recovery had lost momentum.  “We were particularly struck by the size and correlated nature of the market moves,” said El-Erian.
  • Correlation may be linked to the increased use of exchange-traded funds and index funds in the stock market, especially those that focus on particular industry groups, said Brian James, co-director of equity research at Boston-based Loomis Sayles & Co. Assets in U.S. ETFs have grown to more than $821 billion from $608 billion at the end of 2007, according to Investment Company Institute.  “It is almost axiomatic that if you have an increased presence of single-purpose ETFS and futures traders, it moves stocks in one direction,” said James.
  • Correlation has been particularly pronounced for companies with larger market capitalizations, and for the larger funds. James said that 90 to 95 percent of large-capitalization stocks have tended to move in the same direction this year, up from about 70 percent prior to the 2008 financial crisis.
  • The largest U.S. stock fund, the $148 billion Growth Fund of America, has seen correlation increase to 0.99 this year, from 0.84 in mid-2008.  For the $37 billion Dodge & Cox Stock Fund, run by San Francisco-based Dodge & Cox, the correlation measure was also 0.99 this year, compared with low of 0.81 prior to the height of the crisis in late 2008.<

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