Baring Their Teeth –
FAANGs Take a Bite Out of the Equity Market

March 2, 2018  | by Mark J.P. Anson, Mark Bennett

Equities | Industry Knowledge | Investment Strategy

Narrow market leadership in the U.S. and Emerging Markets proves challenging for active managers

Narrow markets are not uncommon to equity investors. They tend to manifest themselves during the best of times, as bull markets lengthen, and thematic elements of investing gain popularity. Prior narrow market environments existed in the late 1990’s (we all remember the tech bubble!) and also in 2007, prior to the Great Financial Crisis. The most recent narrow market has been dominated by the headlines of FAANG’s – Facebook, Amazon, Apple, Netflix and Google. These five business models are disrupting all sorts of industries, and with it, their stock prices have soared. Collectively, as a group, the average return for the Fab Five was nearly 50 percent for 2017, compared to the S&P 500 Index return of 21.8 percent. The FAANG’s now account for over 10 percent of the S&P 500 Index and accounted for 4.3 percentage points of the 21 percent return in 2017. When Microsoft, another large technology holding in the S&P, is added in (FAANG’s +), the return contribution goes up to 5.3 percentage points, or a full 24 percent of the return contribution for the full year.

CH1-FAANGSvsSP500

Betting against the FAANG’s + in the S&P was costly in 2017, but given the valuation profiles of these companies, understandable. Valuations for these FAANG + stocks are more than just “stretched” in comparison to the broader market. P/E ratios of 165 times (Amazon), 97 times (Netflix) or high 20’s for Facebook or Google are not easy to swallow. On the other hand, earnings and revenue growth have largely delivered. Amazon and Netflix have both increased sales around 30 percent, while Facebook’s sales growth is even higher, at 45 percent.  Comparisons to the late 90’s tech bubble are probably not relevant, as these companies have sizable earnings and/or cash on the balance sheet to provide more potential upside, but one needs to be comfortable with lofty valuations to buy in at these levels.

This hasn’t been a U.S. market phenomenon only, however. If we turn our attention to the emerging markets, a similar picture emerges as well. Technology represented over 27 percent of the MSCI Emerging Markets Index at year end, and contributed a full 12 percentage points of the 37 percent total return of the index in 2017. Large internet/technology holdings such as: Tencent (+113 percent); Alibaba (+96 percent); Naspers (+90 percent); Samsung (+61 percent); Baidu (+42 percent) and Taiwan Semiconductor (+40 percent) were the drivers of these outsized returns last year, contributing a third of the total index return.  In combination, these six names now accounted for a full 20 percent of the index at year end (double the 10 percent that FAANGs+ account for in the S&P 500). For context, just five years ago, the entire tech sector represented just 14 percent of the emerging markets index. Similar to some of the FAANG stocks, these internet names have experienced explosive growth in a relatively short period of time.

CH2-EMstocksvsMSCI

Narrow markets are difficult for most active managers, as they are typically characterized by thematic drivers leading over broad-based approaches. Prior narrow markets were accompanied by the “average” active manager underperforming benchmarks. This was the case in 1998/1999, 2007 and in 2017. These periods are typically followed by better active management environments, but despite this, the temptation among some investors is to just throw in the towel and move to passive investing. 

Alternatively, we believe that investors can weather narrow markets by focusing on three guiding principles: risk-aware portfolio construction, inclusion of diversifying sources of active return (risk-premia), and an alignment of interest with managers through performance-based fees.  Risk-aware portfolio construction, focused on weighting decisions driven by underlying manager’s active risk levels, places emphasis on portfolios that will not ignore one segment of the market in order to favor another.  In addition to traditional stock pickers, including strategies that generate excess returns through targeted factor exposures and quantitative approaches that are less susceptible to narrow markets challenges can be beneficial.  Any decrease in flat fees, in favor of performance-based fees above the benchmark, has a direct positive impact on net returns, which is important in a market where every basis point counts. 

Authors

X
Mark Anson is head of Commonfund, Chief Investment Officer, and the Chairman of the Boards of Commonfund Capital, Inc. and Commonfund Asset Management Company, Inc.  Previously, he was the President and Chief Investment Officer for the Bass Family Office, which was recognized as Family Office of the Year for 2014 and 2015. He was the President of Nuveen Investments, a full-service asset management company with over $250 billion in assets under management. Prior to Nuveen, Mark served as the Chief Executive Officer and Chief Investment Officer for the British Telecom Pension Scheme (“BTPS”), the largest institutional investor in the UK with assets of £65 billion. In addition, Mark was the CEO of Hermes Pensions Management in London, a £55 billion asset management company that is wholly owned by the BTPS. Prior to joining BTPS, he served as the Chief Investment Officer of the California Public Employees’ Retirement System, the largest pension fund in the United States with over $300 billion in assets. Mark is currently on the Committee of the UAW Retiree Medical Benefits Trust. He also serves on the Editorial Board of MSCI-Barra, the Board of the Northwestern University School of Law, the Toigo Foundation, and the Board of the Chartered Alternative Investment Association. He is a past member of the Board of Governors for the CFA Institute. Mark has published over 100 investment articles in professional journals and has won three Best Paper Awards. He is also the author of five financial textbooks including the Handbook of Alternative Assets, which is the primary textbook used for the Chartered Alternative Investment Analyst program. Mark earned a B.A. in Economics and Chemistry from St. Olaf College, a Ph.D. and Masters in Finance from Columbia University Graduate School of Business, and a J.D. from Northwestern University School of Law, all with honors. He has also received several industry awards in recognition of his leadership in asset management. Last, Mark has earned the Chartered Financial Analyst, Chartered Alternative Investment Analyst, Certified Public Accountant, and Chartered Global Management Accountant professional degrees, and he is a member of the Bar of the State of New York.
Mark J. P. Anson, PhD
President, CEO and CIO
X
Mark Bennett is a member of the Investment team and is responsible for evaluating and monitoring equity managers. Prior to joining Commonfund, Mark was an Investment Consultant for defined benefit services at CIGNA Retirement and Investment Services. He was an asset allocation analyst and consultant for CIGNA-Connecticut General Pension Services, Inc. Previously, Mark was a benefit technician for CIGNA Retirement and Investment Services. He received a B.S. from Bryant College and his M.B.A. from the University of Hartford. Mark is a CFA charterholder and is a member of the Hartford Society of Financial Analysts and the CFA Institute.
Mark A. Bennett
Managing Director, CFA
Subscribe to Insights Blog

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.