Active Managers, as measured by NAAIM, have increased their exposure to U.S. equities to 96.5%. This is quite high, in the 98th percentile of historical readings dating back to July 2006.

Many seem to be interpreting this development as a bearish signal, a contrary sentiment indicator. If active managers have a high exposure to equities, they say, it must be a sign of an impending top.

If we look back at the evidence, is this indeed the case?

As it turns, out, not necessarily. Historically, the forward returns following the highest exposure readings (top decile) are actually above average from 3 months through 12 months.

What about the opposite? Do low exposure readings imply poor returns? No. Here we do find some evidence of a contrary signal, with above-average forward returns from 6 months through 12 months out (note: I say some because the forward returns from 1-3 months out are negative and below average). We last saw such a reading near the February low (22% on February 3).

What gives? How can both high and low exposure among active managers be positive on average when looking out over the next year? And why is high exposure a poor sentiment signal while low exposure of perhaps some value.

Well, active managers tend to (on average) follow the market when it comes to their exposure levels, increasing exposure to stocks as the market rallies and reducing exposure as the market falls. While the correlation is not exactly 1, the relationship is strong enough to say that the exposure index is a pretty good proxy for the direction of the stock market.

But the short-term direction of the stock market is not typically an indicator of future returns. Most of the time, it’s just noise. There are strong periods of past returns followed by strong/weak returns and weak periods of past returns followed by strong/weak returns.

At the extremes, though, the stock market tends to exhibit both momentum and mean reversion characteristics. As I wrote in a recent post, it is one the great paradoxes in markets whereby extreme overbought (momentum) and extreme oversold (mean reversion) conditions tend to both be followed by above-average returns. We should not be surprised, then, to see above-average returns following extreme overbought and extreme oversold readings in this indicator as well.

Beyond a sentiment gauge, is there any value in this indicator for investors?

Let’s take a look. If someone attempted to use the NAAIM exposure levels to manage their exposure to the S&P 500, adjusting the percentage each and every week, how would they have fared?

Since July 2006 (inception of NAAIM exposure index), they would have produced a cumulative return of 49.7% (4.1% annualized) versus a 109.9% (7.7%) return for a buy-and-hold of the S&P 500. That’s 3.6% annualized underperformance.

Now, to be sure, we have been in a bull market for some time and the strategy of reducing exposure as the market goes down works much better in an extended bear market. We saw this in 2007-09 where using the NAAIM exposures would have substantially outperformed the S&P 500 with lower volatility/drawdowns. But in a bull market or bear market that does not last a long time (ex: 2011) reducing exposure after declines and adding after rallies will have a deleterious effect overall and certainly lag a buy-and-hold portfolio. Historically, as such periods tend to be much more common than extended bear markets, an active management strategy that cuts/adds exposure after lower/higher market prices will have a difficult time outperforming.

(Note: This analysis assumes no transaction costs/taxes for the active exposure strategy, which if included would certainly have fared worse relative to a buy-and-hold.)

Does all of this imply that knowing active manager exposure is useless except for periods when they reduce exposure to extremely low levels? Perhaps. Or perhaps we simply do not yet have enough data (only 10 years) to uncover its full value. Regardless, one probably should think twice before using this crowd as a sure indication of a market top or following their exposures blindly in search of better long-term returns.