The big picture – active vs. passive?
Larry Hatheway, GAM chief economist and Head of Investment Solutions
The active vs. passive debate is largely misunderstood because it is misrepresented. Yes, it may be true that as dispersion picks up in markets that the contribution from ‘alpha’ (security selection) will constitute a larger proportion of overall return, which hitherto has been dominated by beta (easily replicated in low cost ETFs). But the fundamental flaw of passive instruments is that, alone, they cannot offer the genuine diversification that lies at the heart of effective investing. Over the past eight years investors have been seduced into believing that a ‘balanced portfolio’ of stock and bond ETFs offers diversification. Instead, the conventional ’60-40’ portfolio has delivered exceptional returns due to simultaneous bull markets in stocks and bonds. But that happy state of affairs is unlikely to last. As output gaps close and monetary policy is normalised the bull market in bonds is coming to an end. And if, as seems likely at some point, the adjustment is volatile, investors will question the value of investing in low cost instruments that are mere building blocks rather than well diversified set of holdings. When interest rates rise and stock prices wobble, the value of an active approach will shift to wealth preservation, which requires active asset allocation as well as non-directional sources of return, neither of which can be met via index-trackers. In short, the value of active is not just in beating upward trending markets, but even more so in the construction and management of portfolio outcomes.
Niall Gallagher, portfolio manager for European equities
Nearly seven out of every ten European equity managers have failed to outperform the MSCI Europe Index over the last five years.* It is therefore unsurprising that investors have concerns over relatively expensive, underperforming active funds and have switched into cheaper index tracking and ‘smart’ beta ETFs. There are some good European equity managers and many outperform over one year, but most fail to sustain their performance over the longer term. We believe this inability to sustain strong performance lies in some part with a lack of understanding, and thereby control over factor style risks within actively managed equity portfolios and the impact on performance when rotations in these factors occur.
Running a high conviction, active approach we use a sophisticated risk-based portfolio construction process to ensure the intensive, value-add stock level research conducted by the team dominate our returns and risk profile and that a handful of oversized factor bets do not drive the portfolio. After all, this is the part investors pay extra for – the alpha neither the index nor smart beta can replicate.
*337 funds out of 497 with a five year track record in the Morningstar European Equity Large-cap Blend sector, in EUR to 31 October 2017.
Thomas Funk, portfolio manager for Swiss equities
The Swiss stock market is characterised by a unique concentration of companies, which have advanced into market-leading positions and become strong players on the international stage, regardless of the size of their market cap. However, even the best were suffering under adverse currency movements such as the Swiss franc strength and the collapse of emerging market currencies for almost 10 years. We consider 2017 the first ‘normal’ year since the financial crisis. The best and fastest growing companies can now again bring their value generation in Swiss francs to the bottom line in terms of profit and cash flow growth. We invest in the most attractive of them and our focus has been rewarded handsomely. The market is differentiating increasingly between the successful and the less successful companies and this benefits active investors like us. Riding the market multiplier up is simply not a viable strategy anymore.
Christophe Eggmann, portfolio manager for healthcare equities
The combination of a deep understanding of disease pathways and the development of new technologies to design drugs has pushed the innovation potential across the industry to unprecedented levels. This rapid pace of innovation has already started to revolutionise the treatment paradigm of many disease areas such as cancer and inherited genetic diseases. Investing in healthcare today is about capitalising on these exciting developments, which we seek to maximise by putting innovation at the core of every single investment decision. We identify areas of high unmet medical need and invest in companies that have incorporated strong scientific rationale into their business models and are developing best-in-class assets in order to add value for our investors over and above the returns potentially available from a passive approach.
Ernst Glanzmann, portfolio manager for Japanese equities
The collective performance of Japanese equity indices over almost three decades suggests that corporate earnings are anaemic, but in our experience the microeconomic backdrop is both innovative and vibrant. Our investment focus is on real leading businesses with sustainable above-average growth and solid management. Moreover, we do not overpay at the point of adding a new stock and we hold on to our carefully chosen 20-30 positions as long as fundamentals permit and/or valuations remain attractive. This strategy, which is characterised by great patience and low turnover, has served our clients well over the last nine years. It could be viewed as confirmation that active management in one of the world’s largest stock markets can add significant value.
Jian Shi Cortesi, portfolio manager for China and Asia equity strategies
Asian equity markets (excluding Japan) are generally still much less efficient compared with their US and European counterparts. Some of these markets continue to be largely driven by retail investors who trade on rumours and stories, while ignoring corporate fundamentals and equity valuations. The quality of broker research also tends to be lower and less comprehensive than in the large, developed countries. This creates more mispriced stock opportunities for active managers to profit from. By following disciplined and proven investment approaches, we are potentially able to generate large consistent alpha in these under-researched markets.
Fixed income in developed markets
Anthony Smouha and Grégoire Mivelaz, co-fund managers of credit strategies (Atlanticomnium SA.)
On certain occasions, such as in the current policy tightening environment, it can pay to have low sensitivity to interest rates, which passive strategies are unable to achieve due to their bias towards securities with the highest market valuations. Unlike a bond index which can be negatively impacted by rising rates, we have constructed our portfolio to protect our investors from the rise in rates that most people expect in 2018. We aim to capture the positive income flow from coupons while avoiding potentially negative exposure to duration. We seek to achieve this by investing about half of our assets in fixed-rate securities and the remainder in fixed-to-floater and floating-rate notes. On this basis, we differentiate ourselves from most passive indices and offer our investors outperformance potential.
Fixed income in emerging markets (EM)
Enzo Puntillo, head of fixed income/emerging markets fixed income
There is a broad opportunity set which can be exploited across multiple dimensions in the EM fixed income space with large fat-tail potentials: countries, segments, crises and recovery outlier stories. Index funds typically have to exclude smaller countries for liquidity reasons which may lead to them missing interesting investment opportunities. The highest costs in our segment are those related to implementation, which are broadly similar in index funds. We believe that the overall poor track record of passive funds in the EM fixed income space compared with benchmarks stems from the aforementioned factors. Therefore, active strategies have generally the potential to outperform benchmark indices in this field, while passive strategies have overall been struggling to keep pace with them.
Tim Haywood, investment director for absolute return fixed income strategies
Unlike index-tracking strategies, an absolute return approach provides active, dynamic exposure to global fixed income markets via a diverse set of assets. In order to deliver absolute returns, the approach needs to be flexible and adaptable, drawing on the experience of the lead-managers and their team. Absolute return fixed income funds aim to preserve capital and consistently deliver positive returns regardless of market conditions. The ability to allocate to different sectors on both a long and short basis at different times harnesses the broadest spectrum of opportunities by accessing multiple and divergent return streams. This inherent flexibility is essential in terms of preserving client capital, in addition to the potential to generate superior returns to those associated with plain vanilla index exposure.
Mergers & acquisitions (M&A)
Roberto Bottoli, portfolio manager for merger arbitrage strategies
An active approach to the risk arbitrage space is crucial, given the intricacies of M&A transactions. In this context “active management” means understanding the specific risk drivers of an M&A deal and assessing how appealing the arbitrage opportunity behind it is. Risks and rewards associated with merger arbitrage need to be reflected in the portfolio construction phase, sometimes requiring quick and decisive action in building or dismantling a position.