Investing in Bernanke – Draghi Markets

Chidem Kurdas

Why did hedge funds as a whole disappoint in 2011? One obvious answer is that active management in general performed poorly and hedge funds are the epitome of active management.

A report from Rob Arnott’s Research Affiliates offers an intriguing perspective by way of explaining why  the firm’s  fundamental indexes fell short of their long-term promise. Though called indexes, suggesting passive investing, these tools have an element of active management—the portfolios are re-balanced so as to increase the weight of undervalued stocks and reduce the weight of overvalued stocks.

“(T)hese strategies do not work in periods when those corrections are not occurring,” John West of Research Affiliates writes. “When all (most) stocks move in the same direction, the amount of relative price movement expected at the individual security level will be minimal…”

You could not make money betting that the undervalued and overvalued will revert to long-term values because correlations between stocks was too extreme. That meant that like Research Affiliates fundamental indexes, many hedge fund and actively managed mutual fund strategies did not work.

Fixed income specialist Jim Bianco explains: “… the actions of people like Ben Bernanke or Mario Draghi matter far more than any specific fundamental of a company.” Markets were dominated by central bank policy, which overshadowed differences between securities.

As a result, the investor’s best option in 2011 was to simply go along with central banks by buying the whole market. That is, passive index investing did better than active strategies on the whole.

Will that change in 2012? We may remain in Bernanke-Draghi markets. But the Research Affiliates report suggests a sharp turn in the next six months: “The day of reckoning will likely come for Greece sometime in the first half of 2012.”

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