Contrafund's Danoff Stymied as Correlation Frustrates Top Stock Pickers
Danoff’s $62 billion Contrafund, which seeks to beat the market by picking stocks whose value hasn’t been fully recognized, has tracked the Standard & Poor’s 500 Index more closely this year than in any year during its four-decade history, according to data compiled by Bloomberg. That’s even as the fund keeps 19 percent of assets in non-U.S. holdings and almost twice as much in technology and consumer-discretionary stocks as the S&P 500.
Danoff isn’t alone. Six of the 10 largest U.S. stock funds show correlations of 0.99 this year, meaning they moved almost completely in sync with the market. Managers are struggling to stand out and attract new money as fear of another crisis prompts investors to move in and out of markets without discriminating between securities, industries or geographies. Robert Doll, BlackRock Inc.’s chief equity strategist, said while stocks moved in lockstep before, this is the longest he has seen correlation persist across markets.
For investors, “2008 was about get out and ask questions later, while 2009 was all about get in and ask questions later,” Doll said in an interview. “We were expecting 2010 to be the year when stock selection would add value, but that hasn’t been the case.”
Moving in Lockstep
Correlation between assets shot up during the 2008 credit crisis, when stocks, commodities, real estate and riskier bonds simultaneously plunged in value. All of those assets rose last year in the biggest stock market rally since the 1930’s and a record rebound in credit markets. Correlation has persisted in 2010 because of concerns over the European debt crisis and weaker economic growth, Doll said.
The correlation between the U.S. equity benchmark and its individual members was 0.81 in the 50 trading days through July 7 and has since remained close to that level, according to data from Birinyi Associates Inc., a Westport, Connecticut-based research and money management firm. That’s almost twice the historical average of 0.45 over the past 30 years.
A higher number means moves in individual stocks are increasingly related to the direction of the index as a whole. A correlation of 1 means both are moving in complete lockstep, while minus 1 describes exactly opposite movements.
The increase in correlation is making it difficult for actively managed funds to beat their benchmarks and produce better returns than lower-cost index products. Investors pulled $191 billion from U.S. stock mutual funds in 2008 and 2009, data from the Investment Company Institute in Washington show. Fears of a global economic slowdown and the European debt crisis resulted in an additional $18 billion in redemptions this year.
Exchange-traded funds that track domestic stock indexes attracted $44 billion in 2008 and 2009, according to the Investment Company Institute.
“Investors are paying a lot of money to be performing average and not that differently from their benchmarks,” Todd Rosenbluth, a mutual-fund analyst with Standard & Poor’s in New York, said in an interview. “You can’t pick any mutual fund, even if has previously been a winner, and expect it to outperform in this market.”
An index fund tracks market benchmarks such as the S&P 500, charging lower fees than actively-managed funds, in which portfolio managers use their judgment to pick stocks. Most exchange-traded funds also mirror indexes and can be bought and sold on exchanges like stocks. The average expense ratio for ETFs was 0.57 percent of assets in 2009, compared with 0.99 percent for index funds and 1.41 percent for actively managed U.S. stock mutual funds, data from Morningstar show.
Mohamed El-Erian, the chief executive officer of Newport Beach, California-based Pacific Investment Management Co., says investors have a “risk-on/risk-off” attitude that leads to sometimes “violent” swings, such as the sell-off in markets worldwide on Aug. 11, after the Federal Reserve indicated that the economic recovery had lost momentum.
The S&P 500 lost 2.8 percent that day, mirroring a 2.7 percent decline in the MSCI World Index. The Dow Jones Industrial Average fell 2.5 percent.
“We were particularly struck by the size and correlated nature of the market moves,” El-Erian, who tracks stock and bond markets on four computer screens on his desk, said in an interview. “Top-down factors were overwhelming bottom-up considerations during a particularly fluid time for the U.S. and global economies.”
‘Scratched Our Heads’
Doll says even the most high-quality stocks have been hurt among a larger sell-off in risky assets. The oil spill in the Gulf of Mexico, for instance, prompted a sale across energy stocks this year, he said. BP Plc, the company which has been held responsible for the accident, declined 33 percent this year through Sept. 3, compared with a 14 percent drop for the 18- member FTSE All-Share Oil & Gas Producers Index.
“We’ve scratched our heads many times during this year as the macro picture is driving everything,” Doll said. “It can be frustrating along the way, but we’re just focusing on the fundamentals and eventually we’ll get paid for it.”
Doll, who is responsible for about $500 billion in stock assets at the world’s largest money management firm, is also the lead portfolio manager for BlackRock’s large cap funds. His $2.4 billion BlackRock Large Cap Core Fund, whose top 10 picks include Exxon Mobil Corp. and Marathon Oil Corp., is down 4.8 percent this year through Sept. 2.
Driven by Fear
T. Rowe Price Group Inc.’s Ned Notzon, who heads the Baltimore-based firm’s asset-allocation committee that distributes money across stocks and bonds, said correlation between stocks around the world tends to rise during market crises and usually recedes after the markets bounce back.
During the market crash following the technology bubble, for instance, the correlation coefficient between the S&P 500 Index and the MSCI AC World Index rose to 0.93 in March 2001 and stayed at those levels through the following year. The correlation abated to 0.86 only in 2003, according to data compiled by Bloomberg.
“The common factor that’s moving the market is fear,” Notzon said. “People’s fears are being exacerbated by weak economic news.”
Notzon, whose unit oversees about $70 billion in assets, is still putting more money in equities because he said he is “nervous” about bonds as interest rates may start to increase next year if economies around the world rebound. On average, Notzon’s asset allocation funds have 63 percent of holdings in equities, and the remainder in bonds.
“We could see decent equity returns over the next 5 to 10 years,” Notzon said. “The global economy is holding together well.”
In addition to fear, correlation may be linked to the increased use of exchange-traded funds and index funds in the stock market, especially those that focus on particular industry groups, said Brian James, co-director of equity research at Boston-based Loomis Sayles & Co. Assets in U.S. ETFs have grown to more than $821 billion from $608 billion at the end of 2007, according to Investment Company Institute.
“It is almost axiomatic that if you have an increased presence of single-purpose ETFS and futures traders, it moves stocks in one direction,” said James.
Correlation has been particularly pronounced for companies with larger market capitalizations, and for the larger funds. James said that 90 to 95 percent of large-capitalization stocks have tended to move in the same direction this year, up from about 70 percent prior to the 2008 financial crisis.
At Eaton Vance Corp. in Boston, Duncan Richardson, the chief equity investment officer, said investors haven’t been differentiating between high-quality stocks, or those with better cash flow, earnings and stability, and lower-quality companies. That has hurt returns of the $16 billion Eaton Vance Large-Cap Value Fund this year. The fund, which aims to beat the Russell 1000 Value Index, has seen its correlation coefficient rise to 0.99 this year from 0.87 prior to the crisis.
“The only thing that goes up in a crisis is correlation,” Richardson said. “It does make it very hard for stock pickers in an environment like this.”
Contrafund’s correlation coefficient is at 0.9864, close to the record of 0.9907 reached in April 2009, according to Bloomberg data. That compares with 0.8438 in the months before Lehman Brothers Holdings Inc. filed for bankruptcy in September 2008.
The largest U.S. stock fund, the $148 billion Growth Fund of America, has seen correlation increase to 0.99 this year, from 0.84 in mid-2008. The fund, managed by a team at Los Angeles-based Capital Group Cos., has declined 3.4 percent this year, 2.5 percentage points more than the S&P 500’s returns, including reinvested dividends.
For the $37 billion Dodge & Cox Stock Fund, run by San Francisco-based Dodge & Cox, the correlation measure was also 0.99 this year, compared with low of 0.81 prior to the height of the crisis in late 2008.
The correlation coefficients were calculated using percentage changes on 120 days of Bloomberg data.
The largest mutual funds are already prone to what is known as “closet indexing,” because the impact of individual investment decisions on overall performance decreases as the funds gain in size, said James Lowell, chief strategist at Adviser Investments in Watertown, Massachusetts, in an interview. “This market is exacerbating these traits.”
Contrafund, whose 15 percent return over the past 12 months beat that of the S&P 500 by 3.6 percentage points, has seen its lead over the benchmark narrow to about 1.3 percentage points this year. The fund has 19 percent of its assets in non-U.S. holdings. About 32 percent are in information technology stocks, compared with an 18 percent weighting that the stocks have in the S&P 500. Consumer-discretionary stocks in the fund account for 18 percent, compared with 10 percent for the U.S. benchmark.
“Danoff usually finds ways to go against the grain, but these days there isn’t much that’s contrarian relative to the macro theme,” Adviser Investments’ Lowell said. “This is a trendless market and it’s not providing him any room to break away from the S&P 500.”
Contrafund’s R-squared or R2, another commonly used statistical gauge that shows how much of a fund’s movement is the result of an index movement, is at its all-time high of 0.97 this year. That means 97 percent of the fund’s movements are explained by swings in the benchmark index. Contrafund in 1969 reported an R2 of 0.08, its lowest ever, according to data compiled by Bloomberg. That year, the fund outperformed the S&P 500 index by 5.6 percentage points.
Danoff’s Track Record
Jennifer Engle, a spokeswoman for Boston-based Fidelity, said in an e-mailed statement that Danoff has beaten the S&P 500 by 3.8 percent annually over his 20-year tenure as manager of the Contrafund and has “remained consistent in his approach to active management.”
“Those results are not achieved by mirroring the index and are indicative of the high quality of his active stock picking,” Engle said. Danoff declined to be interviewed for this story.
Investing abroad hasn’t helped stock pickers like Danoff because correlation has shot up even between regions. The S&P 500 has climbed 0.4 percent this year, including reinvested dividends, compared with a 0.7 percent drop in the MSCI AC World Index. The correlation coefficient between them is 0.89, compared with 0.72 two years ago, just before the credit crisis started unfolding.
‘No Place to Hide’
Correlation between frontier-market stocks and U.S. equities shot up to a record of 0.33 in July, signaling that companies even in the smallest developing countries are more linked than ever to events in major economies.
The synchronized markets have led to “a no place to hide syndrome,” said Chris Thompson, a managing director at Darien, Connecticut-based Rogerscasey, a consulting firm that advises on $265 billion in assets for institutional investors. That has led to a flight into bonds, which have attracted $156 billion this year, and exchange-traded funds, which have gathered about $48 billion.
Thompson says investors shouldn’t get out of actively managed funds if they want a shot at beating the market. During the market declines in 2000 to 2001, fund managers that avoided technology stocks beat the Russell 3000 Index, as technology and telecom stocks made up one-third of the index, Thompson said.
“In periods of extreme market volatility, individual investors capitulate on passive management and lock in market exposure at exactly the wrong time,” Thompson said. “Some active managers can add value.”