Crash of The Titans
Investors are abandoning small caps in favour of big companies, because the behemoths always fare better in tough markets, right? Nope. They don’t…
This year has been a nightmare for most active fund managers, particularly in the US.
Markets have risen, but much of that is because the index’s mega-caps have rallied while most smaller (or, more accurately, less huge) companies have flatlined. Sensibly diversified active processes just don’t work under those conditions.
This happens from time to time. It’s uncomfortable while it does but the relief when it breaks is sweet: many past active management greats made their name by riding out ‘big-only’ periods and then killing the market when the stumbling mammoths brought it down.
Those of a certain vintage may be reminded of the big-is-best consensus at the turn of the century. This culminated with the launch of the Mercury Global Titans fund in 2000. I didn’t buy it, but only because I had no savings. If I had, I’m sure I would have dived in. Its message was compelling: ‘Buy the planet’s biggest and most powerful companies — you’d be stupid to do anything else’.
There wasn’t much to argue with, not without getting into boring stuff like valuations, the limits of scale and potential competition (yawn). It was all, of course, backed by a thumping performance backstory: large caps had thrashed everything else, as the chart above shows.
On 31 January 2000, the fund launched into a world that assumed large-cap outperformance was like breathing: something that reliably happens without having to be thought about. There are still a few fund launch articles on the web from then — look them up to get a sense of the prevailing mood.
And when it came to companies that weren’t global and massive? The turn-of-the-century investor considered them like something they’d scraped off their shoe: ‘Small caps? Eugh! They’re weedy, they’ve done nothing, and they always underperform when markets fall.’
Within three months, the fund had raised more than £100m — a monster sum in 2000. It was a marketing triumph. Yet performance-wise, the fund sank as quickly as it’s near namesake ship.
Like so many marketing-led funds, it was designed to give investors what they want, not what they need. And what investors want is invariably the equivalent of syrup-coated ice cream, leading to a fast high followed by a debilitating crash.
You can see that crash below. The launch marked the top of the mega-cap trend and, despite going straight into the kind of bear market in which small caps supposedly always underperform, small caps surprised by giving it the full David and Goliath. Firstly, by defending better in falling markets, then by rocketing when bear turned to bull in 2003.
Note also the fund’s name changes (first to Merrill Lynch Global Equity, then to BlackRock Developed Markets Sustainable Equity). This was partly due to Mercury being bought by Merrill Lynch (later BlackRock) but also, as Citywire reported in August 2007, because senior management had lost faith in the whole ‘Earth’s mightiest companies’ thing (as had many of its holders). So they cut ‘Titans’ from its name and gave it the flexibility to buy smaller companies (naturally, this heralded the top of that particular episode of small-cap outperformance).
I’m a believer in active management, but this demand-led flip-floppery is a part of the industry that gives the whole thing a bad name.
And it comes from both sides. Fund buyers (including the professionals) persistently chase, then abandon, trends. This encourages short-sighted C-suites to do the same, which then punishes the few holders willing to ride out a tough run as the fund is often pivoted or closed just before the market turns.
Regulations are now in on the act too. Most obviously the mandated value assessments, which force fund management houses to behave pro-cyclically — or excuse them for doing so.
Had value assessments been required in 2000, one fund that might not have survived is Aberforth UK Small Companies. If the Titans fund was pushing on the open marketing door of ‘global, growth and huge’, Aberforth was pushing on the door marked ‘pull’ that was ‘domestic UK, value and small’.
Aberforth was also an independent, investor-led boutique that had been founded on those same principles, so wasn’t about to turn itself into a mega-cap global growth fund. At the time, this attitude was seen as all very square.
Thankfully, for its more patient holders’ sake, the winds changed (as they always do). The Aberforth fund rose by 15% over the next three years, which doesn’t sound like much but was a clear improvement on the 45% plummet endured by global large caps (including a 52% swan dive from Microsoft).
By the time ‘Titans’ was canned in 2007, Aberforth had outpaced it by a solid 250% (see chart).
My rational brain tells me we’re heading for another such pivot (just don’t ask me when). The conditions and attitudes are eerily similar to those of 2000. Not just the unquestioning belief in the markets’ giants, but also the untapped potential building in neglecting the valuations of small caps.
In contrast to my rational brain, my inner chimp is worried that, this time, the rule of the titans may be permanent. Is this the Cruel God of Markets again? That mischievous deity whose greatest pleasure is tricking us into doing exactly the wrong thing?
My chimp’s fear is that, given their massive influence on market direction, and the importance that central banks and consumers now attach to the market, the new batch of mega-caps have become too big to fail. That, even if they are detached from reality, they have become quasi-government-backed securities to be bailed out on behalf of sheep-like investors if they get too wobbly.
Are they detached from reality? I’m no stock analyst, so my opinion is worthless here. Instead, my stock decisions are made by the hive mind of experienced, diverse and selective fund managers that forms my equity portfolio (almost all of whom have their own money invested in their funds). Within that, there’s some exposure to one or two of the titans, and zero exposure to the others.
But, compared with a global index, my trusted managers’ collective exposure is tiny. Even if their decisions aren’t flashing a red light on titan-cap fundamentals, they’re suggesting there are better opportunities elsewhere. So, as I trust them more than my inner chimp and can remember the last time the titans crashed, that’s where my exposure sits.
This article first appeared in Citywire in June 2022.