Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the pandemic’s best stock pickers, the Archegos shakeout, bearishness in U.S. Treasuries, and a justification for active management. To sign up for the Capital Note, follow this link.
Pandemic Produces Big Winners
The COVID-19 market meltdown was an opportunity for long-underperforming fund managers to demonstrate the superiority of active stock selection in volatile markets. A decade of accommodative monetary policy made life difficult for stock pickers, who tend to perform better in volatile markets.
Did active funds rise to the occasion? Yes and no. The Wall Street Journal reports that, on average, mutual-fund stock pickers performed about as well as benchmark indexes in 2020, but the best performers beat the S&P 500 by as much as 200 percent — well above the alpha of 20–30 percent delivered by 2019’s top funds.
Most of the year’s gains came from small-cap tech stocks, which benefited from a pandemic-driven transition to digital commerce, as well a reduction in interest rates that increased the net-present value of long-term earnings. Morgan Stanley’s Dennis Lynch, who topped the Journal’s rankings, returned 273 percent with a concentrated portfolio of high-growth tech stocks.
One of Lynch’s best performers was Fastly, an “edge cloud” computing business that grew rapidly during the pandemic. Fastly shares went from $14 at the depths of the COVID-19 sell-off to $126 in October of last year. The company also delivered big wins for tech-focused hedge funds such as Abdiel Capital and Whale Rock Capital.
Ron Baron, a perennial leader in mutual-fund rankings, had another stellar year driven by his large holdings of Tesla. The Baron Partners Fund didn’t trade around the March 2020 sell-off, but instead doubled down on the high-growth tech stocks that have long driven the fund’s performance. On top of Tesla’s rally, a large holding in real-estate platform Zillow led to a 220 percent gain for the fund. Michael Baron told the Journal that “a lot of growth projections we had established for our holdings for the next several years were pulled forward, and realized in a much shorter timespan.”
Other top performers actively rebalanced their portfolios around the pandemic. Driehaus Micro Cap Growth, which returned 175 percent, bought up shares in e-commerce platforms that would benefit from COVID-19 lockdowns, as well as biotech business involved in COVID-19 testing. Others top performers were bolstered by pandemic stocks such as Zoom Video and DraftKings.
While blockbuster returns for the best-performing mutual funds are not likely to spark a broader active-management renaissance, they do show that stock selection matters in volatile markets. Going into 2021, however, a changing market environment will test 2020’s top performers. With real interest rates rising and investors “rotating” away from technology stocks, funds that have driven returns with growth strategies may lose out. The shakeout will show whether stock selection can drive persistent gains in a changing macro environment.
Around the Web
Credit Suisse loses $4.7 Billion in Archegos blowup
Credit Suisse revealed a $4.7bn loss from the blow-up of Archegos Capital and unveiled a dramatic management overhaul, jettisoning at least seven senior executives, traders and risk managers as it reels from twin crises involving the family office fiasco and collapse of Greensill Capital. Lara Warner, the group’s chief risk and compliance officer, and Brian Chin, head of the investment bank, are set to depart, Credit Suisse said on Tuesday.
Fidelity teams up with crypto exchanges to form lobbying group
Fidelity Investments, Square Inc. and several other financial firms are forming a new trade group that aims to shape the way bitcoin and other cryptocurrencies are regulated. The Crypto Council for Innovation will lobby policy makers, take up research projects and serve as the burgeoning industry’s voice in championing the economic benefits of digital currencies and related technologies. Crypto investor Paradigm and Coinbase Global Inc., which operates a cryptocurrency exchange, also signed on as initial members of the group.
Bets against Treasury ETFs hit four-year high
Short interest in the $14 billion iShares 20+ Year Treasury Bond exchange-traded fund (ticker TLT) has climbed to about one-fifth of the shares outstanding, the highest since early 2017, according to data from IHS Markit Ltd. Bearish bets have risen from 7% at the start of 2021 amid the fund’s 13% year-to-date drop. While the bond selloff that’s hammered TLT appears to have leveled off with 30-year yields hovering near 2.4% for the better part of a month, the surge in short bets suggests investors don’t expect the calm to last long.
Random Walk
The debate over active management tends to focus on market volatility, measured by the VIX. A recent paper in the Financial Analysts Journal suggests that fund-level volatility is a good predictor of performance, too. The authors find that mutual funds tend to outperform following periods of low volatility, and vice versa:
Increasing (decreasing) investment in an actively managed mutual fund when fund volatility has recently been low (high) leads to a significant improvement in investment performance. Specifically, volatility-scaled fund returns exhibit significantly higher alphas and Sharpe ratios than the original (unscaled) fund returns. Scaling by past downside volatility leads to even greater performance improvement than scaling by total volatility. The superior performance of volatility-managed mutual fund trading strategies is attributable to both volatility timing and return timing. Fund flows are negatively related to past fund volatility, suggesting that fund investors are aware of the benefit of volatility management.
The finding explains in part why there is so much money under active management despite underperformance. The authors explain, “Volatility-scaled trading strategies lead to positive alphas, thus providing at least a partial justification for investing in actively managed mutual funds.”
— D.T.
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