Volatility And Active

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Royce Funds
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volatility

Co-CIO Francis Gannon discusses the disconnect between the markets and the economy.

Q2 hedge fund letters, conference, scoops etc

How volatile was the market during the second quarter?

Volatility surprisingly in the market moved down in the second quarter after rising dramatically in the first quarter of this year. So 33% of the trading days in the Russell 2000 were 1% moves in the first quarter of this year, and that dropped to 19% in the second quarter of this year, and contrast that, you know, year to date, we’re about 26% versus 40% over the past 20 years.

More Volatility Looks Likely

Percentage of Trading Days with Moves of 1% or More in the Russell 2000 Through 6/30/18

volatility

The average percentage includes data from 1998-2017 and does not include YTD data.

So we do think that volatility is going to increase. I think many investors were lulled to sleep last year by the lack of volatility in the overall market. But as an active manager, higher volatility we think is a positive thing. And you should be seeing more volatility in the market going forward. Volatility, important to note, is not mean reverting, so it does tend to happen in pockets and we think that’s actually quite healthy.

Why do you think that the economy and market look disconnected?

There does seem to be this dislocation, or almost dichotomy between the markets and the overall economy. Clearly evidence is presenting itself showing that the domestic economy is getting stronger. We’re seeing that only from earnings, but we’re hearing it from businesses as well. The overall tone that we hear from the business is actually quite positive. Yet the market seems to be focusing on many of the businesses that have worked before.

So in the second quarter we saw healthcare do quite well. We saw non-earners do quite well. We saw bond-like proxies do well for periods of time. And I think part of that is just the market being the normal market. Investors are tending to focus on what has worked in the past, as opposed to looking out three to five years. Our job as fundamental investors is to look at the underlying fundamentals of the companies in front of us, take advantage of those market moves when we can.

Why is higher volatility better for active managers?

Higher volatility portends well for active managers. Lower volatility tends to help out passive managers.

Percentage Active1 Beat Russell 2000 Within Volatility Levels

Monthly Rolling 5-Year Average Annual Return Periods 12/31/78 through 6/30/18

volatility

1 “Active” represented by Morningstar’s U.S. Small Blend Fund. There were 539 U.S. Small Blend Funds tracked by Morningstar with at least 5 years of performance history as of 6/30/18.
Standard deviation is a statistical measure within which a fund’s total returns have varied over time. The greater the standard deviation, the greater a fund’s volatility.

And over the past seven years, we’ve seen a variety of moments where volatility has been quite low, and passive has done quite well. One of the things we think as we get to a more normal environment going forward is that you’re going to see higher volatility. It’s part of the reason why we believe active managers should do better going forward.

Article by Francis Gannon, The Royce Funds

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For more than 40 years, Royce & Associates, investment adviser to The Royce Funds, has used a disciplined, value-oriented approach to select micro-cap and small-cap companies.

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