When Ricky Sandler of Eminence Capital invested 10 years ago, he focused most of his attention on the businesses behind the stocks he bought. Today, he spends 20% to 30% of his time focusing on the stock — and the behaviors of those investing in it — with the remaining portion spent on the business behind the stock.
SUN VALLEY, ID – JULY 08: Ricky Sandler, founder of hedge fund Eminence Capital, arrives for the … [+]
With retail investors taking the markets by storm, their behaviors are sending ripple effects through the markets, and Sandler now factors them into his decision making. In a recent interview, Sandler discussed his views on how investors’ behaviors are shaping the current state of the markets.
He also shared some data that shows how those evolving behaviors have led to structural changes in the markets.
Changing market structure
For example, Sandler noted that almost 60% of assets under management by mutual funds are now being passively managed as of 2024. This is up dramatically from 10 years ago, when just 38% of mutual fund AUM was passively managed.
Most passively managed funds tend to own the same stocks in the same weightings because they usually track a particular index like the S&P 500. As a result, this investor behavior is driving increased crowding in certain stocks, especially large-cap technology names.
Meanwhile, the household share of U.S. equities has risen steadily over the years, climbing from 32% in 2013 to 42% in 2023. The implications are higher prices and lower returns in crowded equities.
According to the National Bureau of Economic Research (NBER), a shift of only 0.1% of household portfolios toward equities was associated with a 10% increase in equity values. The American Economic Association also found that at the height of the dotcom boom in March 2000, household equity share was high at 81%, while excess stock-market returns were poor, off 3.7% per year over the five years that followed.
On the other hand, household equity share was low at 52% at the bottom of the financial crisis in March 2009. The excess return over the following five years was 18.2%.
The NBER agrees with Sandler that behavioral reasons are likely driving return forecasts related to household equity share.
This dramatic reduction in actively managed AUM by mutual funds is a symptom of another change Sandler noted in the market structure: a sizable drop in fundamental investing. According to Eminence Capital, just 32% of hedge fund AUM is invested with fundamentally driven funds, versus 44% in 2010.
On the other hand, PivotalPath noted a drop in total AUM managed by quant funds, although the firm has also found that allocator interest in this strategy has jumped significantly.
“The PivotalPath Equity Quant
Quant
The good news resulting from all these AUM changes by fund type is that they leave more opportunities for fundamental, active investors like Eminence Capital.
“When the price setters in the market are not fundamental, bottom-up investors, it causes stock prices to deviate more materially from intrinsic value,” Sandler explained. “This is both an opportunity and a risk for the true fundamental investor. It is an opportunity in that there are greater dislocations and mis-pricings to take advantage of. This is good. It is a risk in that fundamental investors can see unusual and unexplainable mark-to-market activity in their portfolios, causing increased P&L volatility. It also presents a potentially false signal to the fundamental investor that presumes this price action is meaningful.”
Thematic investing
An increase in thematic investing is also opening up more opportunities for Eminence Capital and other fundamental investors. Sandler said lots of firms are creating custom baskets covering a variety of themes like unprofitable growth, artificial-intelligence winners, GLP-1 losers and others. As of 2024, a massive $348 billion is invested in thematic baskets.
As a result, Sandler sees significant dislocations in the market because if a company is placed in a certain bucket, investors either buy the stock for being on the right side of a particular theme or sell it because it’s on the wrong side. However, he added that bottom-up managers like Eminence Capital see significant opportunities in uncovering lots of mispricings.
Sandler said fewer investors are doing bottom-up work right now. That creates an opportunity for thoughtful teams researching companies and taking a five-year view on the business and a two- to three-year view on the stock — going beyond all the short-term noise.
“Fundamental investors need the confidence and conviction to ignore price action,” Sandler added. “Price action in the market is no longer a signal. It used to be that when fundamental investors were more material actors in the market, then the price action they drove was a little bit of a signal. Today, it’s being driven by retail investors, quants, pods [and] people doing things for totally different reasons.”
In response to how allocators have changed, in part due to these evolving opportunities for fundamental investors, Eminence Capital launched a new strategy about a year ago: Alpha Extension/150×50. The alpha extension strategy includes the same long and short equity positions as the Eminence long/short strategy, but positions are resized to target 150% long exposure and 50% short exposure.
In its first full year, the fund generated an additional roughly 600 basis points of outperformance relative to Eminence’s long-only fund over that period. A 10-year back-test of the alpha extension strategy also demonstrated outperformance over the long fund.
The new fund joins Eminence’s long/ short hedge fund with a 25-year track record and the long strategy that launched 12 years ago, which is now the firm’s biggest business, accounting for over half of its AUM.
Stock vs. company
The new alpha-extension strategy takes into account some of the new things Sandler and his team are doing today as their stock-picking strategies have evolved. According to Sandler, they could focus all their research on the business as recently as 10 years ago. They considered where the company will go over the next two to five years. In the past, if they got the business and valuation right, everything else would take care of itself.
However, all the behavioral and structural changes discussed above have led them to make this change. A more recent focus has been on the company’s stock rather than just on its business. While the Eminence Capital team still does work on where the business will be in the next five years, Sandler said they also have to consider what other investors are doing with that stock.
“Why are they selling this or buying this? What is the narrative? Essentially the sandbox that we play in has changed,” he explained “… Maybe 20% to 30% of our time is researching the stock: who owns it, what are the tension points, what would get them to change their opinion, who’s shorted, where is sentiment leaning long or short? These are the kinds of things that create extra return opportunities for us.”
Sandler emphasized that investors shouldn’t be afraid of other investors’ behavior, but they should understand why they’re acting like that. In short, Sandler said they look for “the kind of business that somebody might want to buy in 18 months.”
Other implications of all these changes
Whenever major shifts occur in the market, the implications of those changes also shift. According to Sandler, individual stocks are now displaying significantly more non-fundamental price volatility.
As such, the market is as inefficient as ever at the individual stock level. Sandler believes fundamentals and the future outlook are still very relevant over the next one to three years.
Further, he said the changes to the market’s structure require adjustments to thinking and mindset around stock-price “action.” Sandler also highlighted the need to incorporate an understanding of how these new market participants behave into investment frameworks.
Adding that portfolio turnover must increase, he noted that active managers can also use volatility to their advantage. Other key implications include understanding and being aware of factor tilts in portfolios.
Sandler said short portfolios especially need to be balanced in terms of style and factor and more diversified. Because of the need for diversification and balance, single-name shorting requires a scaled research infrastructure.
“Capital is managed quite differently in the equity markets today,” he concluded. “The players and how they approach investing are materially different than 10 to 15 years ago. This necessitates a change in the mindset and the approach for fundamental investors to be able to navigate and capitalize. It is a bigger and better opportunity, but with different risks that need to be understood.”