The market environment has certainly been challenging for active managers in recent years, with the advent of quantitative easing across much of the developed world aggressively distorting equity markets. Earnings growth has been low as the world has recovered from the bust of 2008, while asset price inflation has been high. With interest rates low globally, correlations between assets and also within asset classes have been high which has led to a challenging period for active management. More importantly with correlations high, it has been harder for fund buyers and selectors to differentiate between good and bad asset managers.
But it has been a very different picture so far in 2017. The end of quantitative easing is nigh and interest rates are rising, at least in the US, as part of the start of a period of normalisation in global monetary conditions. With this significant shift in policy, active management has returned to the fore.
And we think there is more to come.
The macro economic backdrop for equity markets is changing. As we have already noted, interest rates have begun to climb in the US, albeit slowly. A rate rise in the UK is not impossible in the next year, while economic data and ECB rhetoric firmly suggest that quantitative easing in the eurozone will be curtailed through 2018. We expect stock correlations to continue to fall and dispersions of returns to rise. Low correlations between individual stocks and a high dispersion of returns between the best and worst stocks within a sector (known as cross-sectional volatility) create a fertile environment for an active stock-picker with a clear and consistent investment process.
With markets having risen so strongly from their lows in recent years, we should also be aware that dispersion can be amplified by market direction. Put simply, when market downturns occur, this is when dispersion increases the most and active managers add the most value. We are now eight years into this current equity bull run. There will be a time soon when active managers really prove their worth to the discerning client.
Lastly, some markets are simply less efficiently valued than others and this is structural rather than coincidental. In some asset classes, therefore, we see substantial and persistent opportunity for active security selection.
There is a raft of research which asserts that the average actively managed fund underperforms its benchmark index net of all fees. However, there are some clear reasons why this is the case and it neither implies a lack of opportunity nor a dearth of skilled investment professionals. The really important point is that a large number of managers align their portfolios so closely to the benchmark index that they make it difficult to outperform on a net-of-fees basis. For example, a fund with a tracking error of 3% and a total expense ratio of 1.5% can only deliver net relative performance in the range of -4.5% to +1.5%. In other words, the chance of underperforming the benchmark over any randomly selected period is three times that of outperforming.
An influential research paper published in 20131 coined the term ‘closet indexing’ to describe the practice of hugging the benchmark index while claiming to be an active manager and levying fees for active management. The author also asserted that ‘active share’ can serve as a useful guide in differentiating between closet indexers and those that genuinely seek to add value for their investors.
Interestingly, an earlier study2 found that, across the US asset management industry, the percentage of actively managed funds with an active share above 80% fell from around 67% to 20% between 1986 and 2009, while those with an active share of 0-20% (closet indexers) rose from 2% to 15%. This dynamic probably reflects a greater fear of materially underperforming the benchmark than an ambition to outperform. The irony is that, in pursuing such a ‘safety first’ approach, closet indexers have effectively advanced the case for passive management, which otherwise would probably not have been viewed as such a compelling alternative.
In essence, every single index tracker pursues a capitalisation-biased, long momentum strategy. This means that, by definition, they buy high, sell low and passively contribute to the inflation and bursting of asset bubbles. The same can be said of closet indexers. Conversely, truly active managers are ideally placed to exploit the valuation anomalies created by the indiscriminate buying and selling of the capitalisation-weighted market.