Why was 2018 a difficult year for investors?

2018 was a difficult year for active managers. Equity market performance was concentrated in the US, and even within the US it was concentrated in the technology sector, and even within that it was concentrated in a small number of mega-cap tech stocks known as the ‘FAANGs’ (Facebook, Apple, Amazon, Netflix, Google, although Microsoft and others have also been included in various versions of the acronym). When performance is concentrated, diversification is effectively penalised, not rewarded. Outperformance of active funds themselves was therefore concentrated in those funds that followed a concentrated, growth-oriented style in the US. That’s quite a specific subset of active portfolio managers, while the rest tended to underperform in a difficult year.

Similarly, 2018 was a year when expensive (based on price-to-earnings ratio, price-to-book ratio, etc.), low quality (low earnings, low profit margin) stocks outperformed. If logic suggests that one should invest in cheap, high-quality stocks then active managers that followed this logic underperformed. Systematic and quantitative equity managers were hit especially hard because their models are based on empirically built frameworks that use past data which would not have suggested buying expensive low-quality stocks.

In the fixed income space, yields were compressed by involvement of policymakers in the market through quantitative easing. The Federal Reserve was undergoing a hiking cycle while the European Central Bank was staying loose leading to further asynchronization in the global context.

A confluence of these factors were caused by – and led to – some distortions in the market, with one example being that volatility was at all-time lows. At the start of 2018 there was a volatility event that saw short volatility speculators forced to cover (close) their positions, leading to a spike in volatility and a drawdown in equity markets. Some referred to this as a ‘Minsky moment’ whereby a period of calm necessarily presaged a period of higher risk, catching out those who had become complacent.