Q1 2016 MARKET REVIEW
The first three months of 2016 tested investors’ fortitude in the face of extreme market volatility. Hopes were shredded as the S&P 500 plunged more than 7.93% in less than two weeks, the worst January start in stock market history.
Investors fretted as the media hyped fears of a faltering China, tepid growth, and the specter of currency wars as interest rates bottomed out around the globe. And yet, despite intense volatility, the markets defied the pundits to end the quarter on stable ground, with most sectors recording a positive finish. The broad US stock market squeaked out a gain of just under 1%, unremarkable until one compares it to the -10% loss sustained earlier in the quarter. Other indexes had even wilder swings, including the Russell 2000 Index (ending the quarter at -1.52 after being down -16%) and Emerging Markets (ending up 5.71% after being down -13.28%). Meanwhile, utilities positively glowed, adding 11.4% in Q1 after dropping -8.4% in 2015.
If there’s one lesson from Q1, it’s that the markets are very good at defying expectations. The pain was particularly acute for actively managed funds, which collectively had their worst quarter in nearly two decades. Following a look at the numbers, we’ll share more about what’s happening in the actively managed fund world, including the tidal wave of outflows to passively managed index and ETF funds.
Q1 AT A GLANCE
WORLD ASSET CLASSES
Emerging markets outperformed developed markets, including the US. Global REITS had the highest returns at 6.93% for the quarter. The value effect was positive in the US and emerging markets, but negative in developed markets outside the US. Small caps outperformed large caps in non-US markets, but underperformed large caps in the US and emerging markets.
The broad US equity market recorded a slightly positive return for the quarter, with value outperforming growth across small, mid-cap and large-cap indices. Large caps outperformed small caps (1.35 vs. -1.52). Small-cap growth performed worst of all at -4.68 for the quarter.
INTERNATIONAL DEVELOPED STOCKS
Outside the US, developed markets lagged both the US equity market and emerging markets. Small caps outperformed large caps (.60% vs. -1.95%) in non-developed US markets. The value effect was negative in non-US markets using broad market indices. Large-cap value underperformed large-cap growth (-1.95% vs. -1.35%). In small caps, however, value indices outperformed growth (1.18% vs. 0.39%).
EMERGING MARKETS STOCKS
Emerging markets outperformed developed markets including the US, with value outperforming growth (7.79% vs. 3.66%) across all size ranges. Large cap indices outperformed small caps (5.71% vs. 0.97%).
SELECT COUNTRY PERFORMANCE
In developed markets, Canada recorded the highest country performance (11.85%) followed by New Zealand (9.29%). The worst performers were Israel (-7.85%) and Italy (-10.74%). In emerging markets, Brazil and Peru recorded the highest country returns (27.87% and 27.02% respectively), while Greece was lowest at -10.16%, followed by China at -5.36%.
REAL ESTATE INVESTMENT TRUSTS
It was another strong quarter for REITs, with developed-markets REITs ex-US posting a strong 8.60% and US REITs turning in 5.12%, handily outperforming US equity indices.
After a poor performance in Q4 2015, commodities turned in a mixed performance in Q1 2016. The Bloomberg Commodity Index Total Return gained 0.42%. Precious metals performed well, with gold posting a solid 16.40% gain, followed by zinc at 12.32% and silver at 11.87%. The worst performers were in energy, with natural gas at -21.81%, followed by unleaded gas and WTI crude oil (-11.81% and -11.58% respectively). Grains were slightly positive. Soybean oil gained 10.44%, but corn fell -3.33%. Livestock was mixed, with lean hogs gaining 7.30% and live cattle falling -2.51%.
Interest rates across US fixed income markets generally decreased during Q1. The yield on the 5-year Treasury note fell 55 basis points (bps) to 1.21%. The yield on the 10-year Treasury note fell 49 bps to 1.78%, and the 30-year Treasury bond fell 40 bps to 2.61%. The yield on the 1-year Treasury bill dropped 6 bps to 0.59% and the 2-year Treasury note fell 33 bps to 0.73%. The 3-month T-bill increased 5 bps to yield 0.21%, and the 6-month T-bill decreased 10 bps to 0.39%.
In corporate bonds, short-term gained 1.16%, intermediate-term returned 2.76% and long-term returned 6.83%. Short-term munis returned 0.71% while intermediate-term munis gained 1.55%. Revenue bonds slightly outperformed general obligation bonds.
It’s anyone’s guess as to what comes next. Some analysts are wary of the earnings outlook and overvaluation, while others see good news in declining deflation risk and recent unemployment data. As for us, it’s the same old advice. Stay diversified. Adhere to a long-term strategy tuned to your personal needs and risk tolerance. Don’t trade on good news or bad. As tough as last quarter was, passive investors captured the rewards of the market, a far better performance than the large majority of active fund managers can claim.
ARE INVESTORS SEEING THE LIGHT?
While investors were fixated on whipsawing markets, active managers were trying to staunch the flow of red ink on their balance sheets.
According to a report issued by BofA Merrill Lynch, actively managed US mutual funds underperformed the stock market by the greatest margin since the bank began keeping records in 1998.
The numbers are dismal: 81% of US equity funds and an almost unbelievable 94% of large-cap funds failed to beat their benchmarks. Value funds did only slightly better, with some 80% falling short of their benchmarks. Blended funds did the best, with a 70% failure-to-beat-the-benchmark rate.
Early April brought plenty of Monday-morning quarterbacking. Fund managers got the direction of the economy wrong; they were wrong about interest rates; momentum strategies failed, and so did high-beta strategies. All of which provides cold comfort to investors who lost so much.
The collective Q1 failure of active fund management accelerated the trend, already underway, of money moving into passively managed investment vehicles. “Investors are voting with their feet,” said Jeffrey Park, head of fund research at Morningstar. “The flows into passive strategies have been torrential, and have mostly been funded by redemptions from active funds.” (Financial Times, 4-April 2016.)
Actively managed funds saw an outflow of $34.9 billion globally this year, with much of that money moving into passive investment vehicles and ETFs, which took in $7.6 billion in the same time period. Meanwhile, assets held in US passive investment vehicles increased to 40% of total US equity fund assets, up from 18.8% just a year ago. (Financial Times, 11-April 2016.)
If investors are waking up to the benefits of passive investing, that’s a good thing. If the outflows continue, we may be seeing major overhauls in the world of active investment management. The question is, what slick strategies will they come up with next? And will investors still be as gullible? Time will tell.