A review of academic research on actively managed funds backs data on active manager outperformance during February’s coronavirus-fueled markets fallout.

A majority of actively managed U.S. large-cap equities mutual funds were worth their salt during February’s coronavirus-driven selloff, with 60% beating their Russell 1000 benchmark, according to Bank of America Merrill Lynch. “The average fund outperformed their benchmark by 26 basis points (bps), down 7.8% on average.”
Strikingly, “February’s strong performance came despite a worsening market environment for active managers: pair-wise stock correlations rose to the highest level since the fourth quarter of 2018,” Merrill noted in its March 2 report . That suggests the market has become “more clustered and return dispersion fell to the lowest level since the second quarter of 2015.”

Normally, tighter return dispersion should make it harder for active managers to generate alpha, or excess return relative to that of its benchmark. How did this happen? Hasn’t the academic consensus made it clear that low-cost passive investing is superior to hiring portfolio managers who select stocks based on business fundamentals, valuations and assessments of future prospects?

Perhaps the way many researchers have conducted their studies has something to do with it? Confirmation bias may influence which factors are included, and which are excluded in research methodology. That’s the gist of one contrarian paper from three professors that was recently published in the Financial Analysts Journal. Their summary finding is worth quoting at length:

“Overall, our review of the literature suggests that the conventional wisdom judges active management too negatively. We conclude that the academic literature during the past 20 years shows that active managers have a variety of skills and, in many cases, tend to make value-added decisions. In other words, many funds do appear to create value for investors even after accounting for fees. We believe the conventional wisdom fails to account for the positive findings of recent research on active manager skill.”

The type of benchmark and the quality of data available have meaningful impacts on the measurement of net alpha, and therefore, the measured skill of active managers, the authors point out. Yet sundry factors go into the selection of stocks: active appraisal of a company’s business model; balance sheet strength; earnings power and visibility into future cash flows; and judgment around how it would fit or complement the broader portfolio. Among many other factors, there’s also the timing of trades: “purchases motivated by valuation considerations outperform the market by a significant margin but purchases motivated by the need to invest excess cash from fund inflows do not,” according to research cited by the authors.

The market volatility reflects investor efforts to price in not just COVID-19, but the responses to it from public health officials responsible for infection transmission control and mitigation measures; monetary and fiscal stimulus meant to offset the economic impact from those measures; business strategy and capital allocation decisions around the potential fallout in terms of, say, supply chain disruption and, crucially, anticipated effects on end-market demand. Will changes in consumer behavior be temporary or lasting?

Josh Rubin, who works on Thornburg’s emerging market strategies, says the team has lately been adding to “innocent bystanders,” which are solid, but beaten up, stocks with purchases funded from proceeds harvested from more defensive holdings. But they’re not blindly buying just anything that’s sold off, and they’re being more wary of adding to names with direct COVID-19 risk. In those cases, they’re continuing to review the severity of the earnings impact and waiting for visibility into recovery to become a little clearer.

“We believe we own companies that should survive no matter how bad it gets, and companies that can see a normal return to demand – perhaps with higher market share – when the virus is behind us, whenever that is,” Rubin says. “We’re generally adding or trimming tactically right now. But if we were to have any concerns about a real structural risk to demand for a companies’ products or services because of this, then we would make a more strategic call to trim or completely sell, it wouldn’t just be a tactical trim.”

One month of outperformance by a majority of actively managed funds doesn’t mean much. But it’s interesting to see Merrill’s report and in-depth critique of the academic literature lend support to Thornburg’s experience in managing through volatile periods. Volatility may cause stock correlations to rise, but for stock pickers sensitive to valuation dislocations, strong companies able to weather the current storm can help balanced portfolios navigate through it and over the long run generate alpha in the process.