The Magnificent Seven’s dominance of international equity returns has caused headaches for fund managers. We spoke to Perpetual Private’s Lydia Kav about what this means for multi-manager portfolios
The year 2023 was a good one for global equity markets. The MSCI ACWI Index returned 22.2 per cent in US dollar terms, with large gains in US equities, where the S&P 500 ended the year 26.3 per cent higher.
But active global equity managers did not do so well.
Across the fund manager universe, managers underperformed the ACWI Index by 1.7 per cent, according to figures from Bfinance.
The results are especially poor in the US, where the SPIVA US Year End 2023 report by S&P Global showed 60 per cent of all active large-cap US equity funds underperformed the S&P 500.
So what happened?
The performance of global indices was driven by a relatively small group of very large companies, or mega-caps, especially the so-called ‘Magnificent Seven’, a group of large technology companies consisting of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
Midway through 2023, it became clear these seven stocks were starting to dominate global markets. A June report from Russell Investments showed that they had already driven 96 per cent of the performance of the Russell 1000 Index by then.
If an investor were to exclude these seven stocks, the return contribution from the other 993 stocks in the index would only be a modestly positive 0.34 per cent, instead of the actual index return of 9.30 per cent at the time.
With so few stocks driving the majority of returns, many fund managers have struggled to outperform.
A lot of active managers have had a hard time with international equities of late, because a lot of investors haven't been in the mega caps and have suffered as a result
For Lydia Kav, Head of Manager Research at Perpetual Private, it was time to take a closer look at the global manager line-up.
“A lot of active managers have had a hard time with international equities of late, because a lot of investors haven’t been in the mega caps and have suffered as a result,” Kav says in an interview with [i3] Insights.
“I’ve seen statistics on active global equity managers, where only 38 per cent outperformed the benchmark last year according to Bfinance. That’s not a good result, albeit being a short timeframe,” she says.
Perpetual Private reviews its asset classes at least once every three years and more often if needed. International equities are now the key focus for Kav and her team.
“We do a really deep review of the portfolio construction of our funds and of the various managers. And international equities, yes, we’ve been in the middle of that currently,” she says.
Although last year’s performance was somewhat unusual with the dominance of the Magnificent Seven, it has been harder for active managers to generate consistent alpha in the international equity space in recent years, she says.
“Because [these markets] are so efficient, global equities and fixed income [managers] struggle with consistent high alpha. So, as a portfolio manager of a multi-manager fund, you really need to slice and dice it a little bit differently.
“You can’t just be diversified across value and growth. For example, fundamental stock pickers and quant could play a role, even passive could play a role,” she says.
Kav is still in the middle of the review and can’t discuss any changes she might make. But considering the efficiency in global markets, and the US equity market in particular, she doesn’t rule out that a quantitative completion strategy could be considered.
It certainly makes sense from a cost perspective.
“You shouldn’t be paying for alpha that just isn’t going to be delivered. You don’t want to drink the manager’s Kool-Aid and believe them when they say ‘we will deliver 1 – 2 per cent alpha’, unless you have high conviction in their track record and process,” she says.
“I think managers can achieve high alpha in certain asset classes, such as PE, but in the larger, more efficient asset classes – and global equities being one of them – it’s a little harder. And I put fixed income in that boat too.
“So, whilst we are open to sleeves of passive where appropriate, we do strongly believe in active management. It’s about accessing alpha where it really is achievable and spending your risk budget wisely,” Kav says.
Portfolio Construction
Kav and her team are not just reviewing managers, they also spend a lot of time on portfolio construction, ensuring promising managers sit well next to each other in the portfolio, keeping an eye on liquidity and avoiding unrewarded risks.
“At the end of the day, we’re portfolio managers and portfolio construction is about getting the mix right, making sure you don’t have unintended basis risk or structural biases,” she says.
“You want to be relatively style neutral, well-diversified across different strategies, but not overdiversified so that you erode total alpha. You need to be practical. So, all those portfolio construction considerations are really important for either the diversified funds or the model [portfolios].”
About 18 months ago, Perpetual Private undertook a review of its Australian equities portfolio and Kav’s team observed there was a structural underweight to the top 20 largest companies listed on the Australian Securities Exchange (ASX).
At the end of the day, we're portfolio managers and portfolio construction is about getting the mix right, making sure you don't have unintended basis risk or structural biases
To remedy this situation, Perpetual took out a passive, ASX 20 mandate with UBS Asset Management.
“We gave a [relatively small] allocation to UBS to fill that gap, because we found all the other managers were underweight the ASX 20. That’s performed really well in the total portfolio context,” she says.
“Now, we won’t be doing something like that in international equities because it’s a different ball game. The top 10 or the top 20 is a large part of the portfolio, so you’re not going to suddenly just have a passive 60 per cent allocation to the large caps.
“We’ve got to be a little bit cleverer and, hence we’re looking at a variety of strategies,” she says.
Tilting
Kav also has the ability to optimise portfolios through a tilting process and the team can overweight or underweight a manager by between 3 per cent and 5 per cent, depending on the fund.
This helped alleviate some of the worst problems during 2022, when Russia invaded Ukraine and market volatility spiked.
“During 2022, we went overweight value and underweight our growth managers. Growth managers were hurting, especially in our Australian equity portfolio, and so our tilts helped and consequently we have performed really nicely in Australian equities.
“But from a macro perspective in our diversified funds, we limit our tilting in more normal environments. We’re not a dynamic shop. The macro considerations of: ‘Are we going to have a recession or not?’, yes, we talk about it, but we always come back to our philosophy that we need to set up our portfolios to ride the full cycle,” she says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.