Anton Lines, a PhD student at London Business School, finds in a recent research paper that US equity portfolio managers who track a benchmark reduce their tracking error in periods when volatility rises. They subsequently redirect their portfolios from their benchmarks again when markets calm down.
In periods when volatility rises most, stocks that fund managers are underweight in versus their benchmark outperform overweight stocks by about 8% per quarter because they are being bought disproportionately by fund managers, Lines finds. Conversely, overweight stocks outperform their underweight equivalents by about 5% when volatility falls most.
Fund managers keep stressing time and again that they welcome volatility because it creates opportunities for stock-pickers like them. Ironically though, Lines’ research suggests that fund managers contribute to market anomalies instead of exploiting them. This may also help explain why a disproportionately low share of US equity managers fail to outperform their benchmark every year, even before costs.
Bonuses to blame?
But why do fund managers reduce their active share when volatility rises? The answer could well be in their remuneration structure. “Managers who are compensated for relative performance optimally shift their portfolio weights towards those of the benchmark when volatility rises,” notes Lines, as both their personal remuneration as well as the flows into their funds tend to depend to a significant extent on relative performance versus the benchmark. Managers tend to shy away from taking the risk that their fund may considerably underperform the benchmark.
However human it is to be afraid of public failure, managers shoot themselves in the foot by taking such an approach. Many investors entrust their money to active fund managers precisely because they are supposed to manage downside risks, which tends to be higher than usual in times of elevated volatility.
Passive funds are taking advantage of active managers’ failure to take risk at the right time. US equity ETFs have seen an eye-dazzling $505bn in net inflows since 2010 globally. This compares to net outflows of $279bn for actively managed US equity funds over the same period. And that’s not only because active funds are cheaper.