The Markets October 6, 2021

Passive Investing Has Performed Well, Even During COVID Crisis

In 15 out of the 18 categories of domestic equity funds considered, S&P Dow Jones Indices finds the majority of actively managed funds underperformed their benchmarks during the year that ended June 30th.

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S&P Dow Jones Indices, a division of S&P Global, has published an updated ‘SPIVA Scorecard’ report that takes into account the impacts of the COVID-19 pandemic, and other major events, on global equity markets during the last year. The report gets its SPIVA name from the fact that it comes S&P operated indices versus actively managed investments.

According to the latest SPIVA report, the S&P 500 had recovered all of its COVID-19-related losses by August 2020, and it posted a 40.8% gain over the 12 months ending on June 30, 2021. Of the 31 distinct benchmarks tracked by the report, 27 finished with a positive return over the year, and the exceptions were among longer-term fixed-income indices.

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As the report authors observe, the positive market performance broadly translated into good absolute returns for active fund managers, yet relative returns compared with passive managers continued to disappoint.

“In 15 out of 18 categories of domestic equity funds, the majority of actively managed funds underperformed their benchmarks,” the report says. “The performance was particularly underwhelming in the small-cap space, as 78% of all small-cap funds lagged the S&P SmallCap 600.”

Report authors Berlinda Liu and Gaurav Sinha, the former a director and the latter a managing director at S&P Dow Jones Indices, say it is worth taking a moment to delve deeper into differences across market cap segments.

“Over the 12-month period, 58% of large-cap funds, 76% of mid-cap funds and 78% of small-cap funds trailed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, respectively,” they write. “At first glance, this isn’t particularly new. SPIVA year-end reports have shown that more than 50% of large-cap funds have lagged the S&P 500 each year for 11 consecutive years. However, fund managers in the mid-cap and small-cap segments have often managed to do better than their large-cap counterparts when the large-cap benchmark had a higher return than the respective mid- or small-cap benchmark, in ways that are not consistent with the ‘greater skill’ premise. Instead, it is more likely that mid-cap and small-cap fund managers are quietly edging into the larger-cap space and benefiting from the higher returns available there.”

Liu and Sinha suggest the reopening gains of early 2021 add one more data-point to this hypothesis.

“As the rest of the market caught up to the large-cap rally of the initial pandemic phase, mid-cap and small-cap managers who tilted up the capitalization scale were caught leaning in the wrong direction,” the authors propose. “Many funds quickly fell short of the benchmark.”

The report also assesses returns of actively managed funds against their benchmarks on a risk-adjusted basis. The authors consider volatility in this analysis, calculated through the standard deviation of monthly returns, as a proxy for risk, and they use return/volatility ratios to evaluate performance.

“After adjusting for risk, the majority of actively managed domestic equity funds in all categories underperformed their benchmarks on a net-of-fees basis over long-term investment horizons,” the authors find. “The few bright spots in the mid-term investment periods were concentrated in mid- and small-cap growth funds and real estate funds.”

Other findings in the report show, in a period of mostly climbing yields, fixed-income funds posted better relative results than their benchmarks. In 12 of the 14 categories tracked, the majority of funds outperformed the relevant index benchmark.

“However, if we widen the lookback window to three years, the majority outperformed in just four categories,” Liu and Sinha warn. “For those with a long-term view, in no fixed income category did the majority of funds manage to surpass their benchmark over a 15-year window.”

Compliance October 6, 2021

Court Rebuffs DOL’s ESOP Valuation Case Against Engineering Firm

One commentator who works in the employee stock ownership plan space says the ruling represents “one of the most comprehensive rebukes of DOL arguments” in such a valuation case.

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The U.S. District Court for the District of Hawaii has issued a decisive ruling in an employee stock ownership plan (ESOP) valuation case known as Walsh v. Bowers.

Writing in the Employee Ownership Blog published by the National Center for Employee Ownership (NCEO), Corey Rosen, NCEO founder and senior staff member, says the ruling represents “one of the most comprehensive rebukes of DOL arguments” in ESOP valuation cases.

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Such cases arises when the government, via the Department of Labor (DOL)’s Employee Benefit Security Administration (EBSA), alleges purchase price manipulation and other schemes that may benefit corporate leadership and company owners at the expense of employees who collectively enter into an ESOP founding transaction.

In this case, the defendants owned all the stock in an engineering firm called Bowers + Kubota Consulting Inc. As recalled in the text of the new ruling, the defendants created an ESOP to which they sold all their shares for $40 million. The EBSA then sued the defendants, alleging that they had violated the Employee Retirement Income Security Act (ERISA) by “manipulating data to induce the ESOP to pay more than the company’s fair market value.”

The new ruling, which was technically filed as post-trial findings of fact and conclusions of law issued alongside an order directing entry of judgment in favor of remaining defendants, determines that no ERISA violation has been established.

“Part of the government’s case is based on a preliminary nonbinding indication of interest by a private company to purchase the company for what the government says was $15 million,” the order states. “That indication of interest expressly recognized that the dollar amount needed to be adjusted to reflect the cash and debt on the company’s balance sheet. Had that adjustment occurred, the quoted dollar figure would have risen to about $29 million. In any event, the company never agreed to sell for $15 million, meaning that that figure did not represent what a willing buyer and willing seller would mutually agree to.”

According to the court’s new order, the indication of interest “ends up having little relevance to the fair market value of the company.” The order points out that the government’s arguments cite an expert who valued the company at $26.9 million, but “because that valuation rests on errors, the court is not persuaded by it.”

“The government does not establish that the company was worth less than $40 million on the day of its sale,” the ruling states. “That is, the record does not show that the ESOP paid more than the company’s fair market value. Nor does this court find that [the defendants] breached any fiduciary duty or are liable for any prohibited transaction, as they demonstrate that the company was worth at least $40 million on the day of its sale. Accordingly, this court, following a one-week nonjury trial, finds in favor of [the defendants] and against the government.”

In the NCEO blog, Rosen emphasizes how the judge ruled that the DOL’s valuation “rests on errors” because its expert failed to follow standard valuation practices, used inaccurate and incomplete information about the company’s finances, and improperly compared the price the ESOP paid to a very preliminary lower offer from another company.

“The court noted that the preliminary offer was likely just a negotiating tool, analogizing that an individual who makes an offer of $15,000 for a used luxury car with a Blue Book value of $40,000 does not, by virtue of making a ‘lowball’ offer that is never accepted, tend to establish that the car is worth only $15,000,” Rosen explains. “The court also noted that the ESOP trustee, while accepting a price very close to what the sellers were seeking, saved the company millions of dollars by negotiating a relatively low rate on seller notes used to finance the deal.”

The full text of the order is available here.

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