FAANG Avoiding Funds Just Had Their Worst Month Since 2009

For professional investors, August was the cruelest month.

In the month when the S&P 500 cleared a new all time high, rising above 2,900 for the first time ever while setting a new record as for the longest "bull market", hedge funds were dazed and confused by the market action, suffering another month of sharp underperformance, and sending their YTD return back into negative territory according to the HFRX equity hedge index.

But it wasn't just hedge funds who suffered the painful short squeezes and sector rotation that prompted Nomura to observe a "multi-month performance disaster for US equity funds": according to Bank of America, "plain vanilla" large cap mutual funds also struggled to match the rally and posted their weakest hit rate in more than two years, as just 22% of funds managed to beat their benchmark in August, while the average fund underperformed its respective benchmark by more than 70bp.

On a year to date basis, less than half, or 43% of large cap funds, have outperformed their benchmark - down from 50% last month - and well below the 55% at the same time last year. As a reminder, most benchmarks - and certainly the S&P - are indexes which most investors can allocate funds to with virtually no costs and management fees, which means that in 2018, more than half the US asset management industry has destroyed value for their investors.

However, that performance is stellar compared to the (under)performance of large cap core, or blended funds which seek to diversify into both value and growth stocks, which had an abysmal hit rate in August of just 13%: this was the worst showing in the the history of Bank of America's data which goes back to 2009.

What prompted this abysmal monthly return? While various factors contributed to the poor performance, BofA strategist Savita Subramanian said that avoiding FAANG stocks was the biggest culprit.

Recall that in the first half, just 4 stocks, Amazon, Microsoft, Apple and Netflix, were responsible for 84% of the S&P upside in 2018. Furthermore, in the first six months of the year, the return of the top 10 S&P 500 stocks of 2018 - which are the who's who of the tech world - saw their collective return amount to 122% of the S&P total return in the first half of the year. In other words, excluding just the top 10 stocks, the S&P's return was negative in H1.

This bifurcated return made a triumphal return in August, when the S&P 500 rose 3%, yet when Apple shares surged 20% while the rest of the FAANGs, Facebook, Amazon, Netflix and Google, climbed 6 percent. Without those five stocks, Bloomberg calculates that the S&P 500’s August gain would have been cut nearly in half to 1.8% .

"Core funds have lagged since early last year, a period during which FAANG stocks have beat the market by a wide margin," Bank of America wrote in Friday note. "Core funds have been chronically underweight FAANG stocks since then, and cut down their relative exposure even further recently."

Or, as Bloomberg puts it, "when the market’s newly created wealth was highly concentrated in these few tech giants, the cost of avoiding them could be disastrous."

Curiously, pure growth funds also dramatically underperformed last month, with just 16% of managers beating the Russell 1000 Growth index. The reason: while growth managers were overweight most FAANG stocks, they were notably underweight AAPL, the main contributor to the growth benchmark's gains. As a result of their August showing, growth funds have all but wiped out their gains from the first half as the group's YTD relative performance dropped from +1.2% last month to +0.1% as of Friday.

And another surprise: while the value strategy has been largely left for dead, in August it was value funds that outperformed the growth peers substantially with 46% beating their benchmark.

Another reason for the abysmal August performance: after the average pair-wise correlation of S&P 500 stocks rose sharply in March with the increased volatility, it has since quickly come down below its long-term average of 26%, indicative of a stock-picker's market. And while most asset manager vow that this is the best time to outperform and generate alpha, the problem is that while most fund managers did pick stocks, they did so... poorly.

This bifurcated performance may be set to continue because the rally in FAANG stocks has drawn numerous warnings from strategists at firms such Wolfe Research, Morgan Stanley and, yes, even Bank of America who made this analysis, who said their gains have gone too far, too fast.

And as long as most investors shun the FAANGs, while others are forced to cover their short positions, the handful of stocks that have led the US market higher in 2018 will continue to do so even as the rest of the market is barely treading water.