Investment managers that focus on active management rely on their ability to analyze securities and build investment processes and strategies that matches the risk tolerances of their investors. The market volatilty driven by the Covid-19 pandemic stresses these endeavors, but it’s really just a long line of events that have generated unforeseen and random volatility in the U.S. capital markets.
These events – the 1987 stock market crash, the surprise Fed rate hikes of 1994, LTCM in 1998, 9/11, 2008 Financial Crisis, and the 2013 Taper Tantrum – tend to be events that are brief, unpredictable and difficult to model within the context of most investment processes. They strike quickly and randomly, often independent of the normal credit and interest rate cycles. Few asset classes are spared in these scenarios; for example, even ultrashort duration fixed income (“USDFI”) investment funds that are structured to be low risk investment pools can experience brief, but sharp, underperformance. Unfortunately, these bouts of underperformance can be severe; in March, the largest open end and exchange-traded USDFI funds underperformed by 5-8 times their historical alpha.
We looked at the performance of the five largest USDFI open-end mutual funds and
ETFs over the Treasury rate cycle from October 31, 2016 to February 29, 2020. This
period saw the U.S. 2-Year Treasury start at 0.84%, peak at 2.96% in November 2018, and close February 2020 at 0.91%, so it’s a good example of a rate cycle round trip. During this period, the annualized outperformance of the open-end USDFI funds was 32 bps and the ETFs came in at 68 bps. However, in March 2020, the average excess returns were -250 bps (open end) and -345 bps (ETFs). Years of steady outperformance were wiped out in a few weeks. The scale of this short term underperformance means that only 2 of the 10 funds we reviewed had nominal outperformance over Treasury fund alternatives from 10/31/16 to 3/31/20.
Of course, we readily admit that we’re missing one part of the cycle, which is the credit recovery phase. Performance has improved since March 2020 and should continue to do so. However, investors were underwhelmed by performance in March; nine of the ten funds we evaluated have fewer assets at the end of March (market-value adjusted) with an average decline of 12%. Anecdotally, we observed actively managed USDFI funds reducing risk as spreads widened because they needed liquidity as redemptions spiked. Critically, this is the exact opposite of what their investment models tell them to do. Investment opportunities are missed because liquidity management dominates risk expansion. These investment strategies ignore the reality of the Client Risk Cycle – not as easy for the quants to model as interest rates and credit cycles, but the results are actually more predictable. We think a better way for money managers to position their
USDFI strategies is to preserve capital when volatility increases, which then allows
managers to rotate into underperforming assets when spreads are attractive.
Unfortunately, it appears their mindset is more aligned with asset gathering and
hanging on when volatility spikes than educating their clients about strategies that
achieve superior risk-adjusted returns.
Originally Published on May 25, 2020
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