For many investors, volatility is often synonymous with risk. We as value investors (and risk managers), on the other hand, have always viewed volatility as a crucial component of active stock selection.
In our latest Royce Research piece, we explore the relationship between low- and high-volatility environments and the relative performance of active managers versus their respective benchmarks during these periods. This deep dive is especially important in a market that has recently seen more volatility and its largest correction in almost three years.
“The past five years have been marked by the rare combination of a remarkable rebound in domestic equity markets and a low-volatility equity environment. This combination has proven to be difficult for domestic equity managers, as over 70% of them across all capitalization and style categories failed to deliver returns higher than their respective benchmarks.” This is the conclusion of the most recent publication of the S&P Dow Jones Indices report, “S&P Index Versus Active” (SPIVA). The piece stoked our curiosity about the relationship between volatility, the recent relative performance of active managers, and the indexes they for the most part have struggled to beat.
For those who may be unfamiliar with this report, the SPIVA Scorecard has served as the de facto scorekeeper of the active versus passive debate since its initial publication 11 years ago. The scorecard presents one-, three-, and five-year annualized returns of active equity and fixed income funds across all asset classes versus their corresponding S&P index. The results are based on a rich data set consisting of the S&P Dow Jones Indexes and CRSP (Center for Research in Security Prices) data. The scorecard also consistently addresses issues related to measurement techniques, universe composition, and fund survivorship.
According to the 2014 Mid-Year SPIVA report, over the last 12 months (periods ended 6/30/14), 59.8% of large-cap managers, 57.8% of mid-cap managers, and 72.8% of small-cap managers underperformed their respective benchmarks. These results led us to further explore the performance of active managers in different volatility environments.
At Royce we always view volatility as an ally; as Warren Buffett (Trades, Portfolio) said, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” So while many investors think volatility is synonymous (or nearly so) with risk, we have never seen it that way. Far from seeing the challenge of managing risk as avoiding volatility, we try to take advantage of market movements—an essential skill for any successful active manager. Those times when the market cannot seem to make up its mind are exactly when securities tend to be most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities. Of course volatility almost always signals a downward shift in returns. However, our study found that outperformance for active manages has not been limited to flat or down market periods historically.
Our commitment to the core principle of embracing volatility made us eager to test the hypothesis of the SPIVA Scorecard. We ran our own study focused on the small-cap space to determine what, if any, relationship exists between volatility and outperformance among active small-cap managers. Although there are many measures of volatility, we chose in our study to use standard deviation, looking at monthly rolling 12-, 36-, and 60-month standard deviations from the inception of the Russell 2000 Index on 12/31/78 through 9/30/14. This gave us an enormous number of data points spanning more than 35 years—418 for the 12-month period, 394 for the 36-month period, and 370 for the 60-month period.
While we usually use periods of only 36 months or longer when using standard deviation, we chose to also look at rolling 12-month periods to be consistent with the SPIVA study. We began by sorting the annual standard deviations from highest to lowest and divided them into quintiles. For each monthly rolling period in each quintile we looked at the corresponding outperformance of the active small-cap manager versus the Russell 2000. We used the Morningstar Category Average for U.S. Open End Small Blend funds as our proxy for the average active small-cap manager. Our results, shown in the tables below, were remarkably consistent.
We found that, on average, active management under-performed the benchmark during periods of lower volatility. The average standard deviations for the Russell 2000 in the lowest quintile of volatility for each period were 10.80%, 12.65%, and 14.16%. During these respective periods, active managers underperformed the benchmark in the 12-month period (while Royce Pennsylvania Mutual Fund also underperformed in the 36- and 60-month periods in Quintile 1). The second-lowest quintile of volatility for each period saw the standard deviation of the Russell 2000 average 14.35%, 16.90%, and 17.49%, and the same pattern continued, with the Morningstar Category falling short only for the 12-month period.
Yet as volatility increased, we saw a marked relative performance advantage for active managers (again, as measured by the Morningstar Small Blend Category Average) in all three periods. We found the widest outperformance spreads in Quintiles 4 and 5 of volatility. For example, in the 36-month periods for Quartile 4 the average annual standard deviation for the Russell 2000 was 22.33% and active management owned 217 basis points of average outperformance.
Looking at each rolling monthly period of standard deviations showed a similar pattern of increased volatility corresponding to an advantage for active management. It’s important to note that this is a correlation—we are not suggesting that volatile markets cause active managers to do better, only that an examination of history reveals this advantage.
While this was wonderful news for active managers in volatile markets, we were equally keen to see how these results worked for our flagship, Royce Pennsylvania Mutual Fund (PMF), which is also shown in the tables. In the 36-month period, the Fund showed an enviable 321 basis points of outperformance when volatility was in the fourth quintile and an even more impressive 455 basis-point advantage in the fifth, while underperforming the index by 208 basis points when volatility was in the first quartile in the same 36-month rolling periods. Relative results versus both the benchmark and the Morningstar Small Blend Category were also strong in Quintiles 2-5 for the 12- and 60-month periods.
Turning to the 12-month period, we find what has been a low volatility environment in which the most recent 12-month annual standard deviation was 14.64%, placing it historically inside the second quintile. We further found that the 12-month annual standard deviations have been stuck in the first or second quintile range since the period (10/1/11 - 9/30/12) through 9/30/14. Needless to say, it has been a highly challenging market for active managers, many of whom (including us) typically rely on volatility to find the mispricing they need to outperform.
It is certainly true that over certain time periods, equity indexes (and the passive funds that track them) will do better than most active managers. And in many instances benchmark indexes have been outperforming relevant peer groups of active managers over 12-, 36-, and 60-month periods. However, there are also going to be reasons for this underperformance—reasons that extend beyond the stock-picking acumen of the respective managers—that are specific to particular funds and/or approaches, and Royce is no exception.
Looking back at our more than 40 years of investment experience, we think there can be little argument that active managers have the potential to achieve benchmark-beating long-term returns. What this mid-year SPIVA study and our own research suggest is that the ideal environment for active management is one in which securities are more likely to be mispriced and markets are less efficient. Using history as our guide, we find that volatility has historically been cyclical. It seems likely that if those market gyrations return, the opportunity for active managers to shine should also.
Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. All performance and risk information reflects Investment Class results. Shares of the Fund’s Service, Consultant, R, and K Classes bear an annual distribution expense that is higher than that borne by the Investment Class. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through it's investment in mutual funds, hedge funds, private equity funds, and other investment companies.
