As we all hunker down to our new normal with the hope that by doing so we can protect others from the invisible onslaught of the coronavirus (COVID-19), those of us in the investment industry are working hard to help ensure we keep client portfolios as healthy as possible against a backdrop of indiscriminate selling driven by sentiment rather than fundamentals. This quest has led us to revisit the aged old debate of active and passive management.
Over the last decade or so roaring equity markets seem to have challenged active management to its very core. Contrastingly, the recent market downturn may offer skilled active managers an opportunity to outperform.
At heart, most investors recognize that recent conditions (central bank quantitative easing and low interest rates), while having lasted longer than expected, were unlikely to persist indefinitely. But huge flows into passive management and ensuing fee pressure on active managers are all signs that investors have had enough. So why is this? And importantly, why have active managers been left behind?
This trend has caused some to wonder whether active managers still have a role to play in equity portfolios. We’ve taken a hard look at the space and believe now is a good time to consider or even re-consider active equity.
A first factor to consider is rising concentration risk associated with passive indices.
Many investors take refuge in the idea that they are making a ‘safe’ choice when they choose to invest passively. The MSCI World Index is made up of around 1,600 stocks, so that means its diversified, right? No, the reality is that the top 100 stocks now make up over 40% of the index and it’s these 100 stocks that now dominate performance.
The problem with this asset concentration, of course, is that should any of these stocks perform poorly, the impact would be significant. And it’s not that concentration risk hasn’t caught out the market in the past either. We need only to look back to the so-called ‘Nifty 50’ valuations of the 1960s to 1970s for an example.
Of course, market cycles, and therefore corrections, are unavoidable and expected when investing. Even when they are triggered by black swan events like COVID-19. But investors need to be astute enough to resist the urge to heavily focus on recent performance and instead recognise that the tables may turn, even if no one can predict exactly when. And, just as importantly, be in a position to be able to do something about it.
The most recent 10 years’ performance has clearly seen passive strategies dominate over active, as reflected in the decline of the median relative performance of active global equity managers versus the MSCI World Index. But could this cycle shift and if so what would the potential implications be?
We know the gap between growth and value stocks in the MSCI World Index has been prolonged for well over a decade now and has recently become historically wide. Looking at longer data we note that styles go in and out of favour over time and the number of days under the sun (or in the shadows) varies.
Each data point is calculated by subtracting the thee-year annualized performance of the MSCI World Growth Index from the three-year annualized performance of the MSCI World Value Index, at monthly intervals. Area above zero indicates periods where Value outperformed Growth. Area below zero indicate periods where Value underperformed Growth.
(Source: MSCI, as at 31 December 2019)
Going forward, we expect a better environment for skilled stock pickers to generate alpha. We believe skilled active managers can outperform. What drove the market up, may well drive it down when the tide turns. The advantage for skilled active managers is that they can be more versatile and respond to changing market conditions more quickly, dodging bumps in the road and working to select the winners (versus the losers) over time. This toolkit will be critical in a sell-off environment.
Thirdly, sustainable investment is a critical factor for long term success and this topic has gained significant momentum in the active versus passive equity debate.
Investors of all shapes and sizes are under increasing pressure to demonstrate their environmental, social and governance (ESG) credentials. This potentially impacts not only the stocks they hold, but also the need to exercise their shareholder voting rights and engage with companies to bring about positive and progressive change in the wider business community. In some markets such as the Netherlands, we are already seeing examples of pension funds working to restructure their portfolios to a more active strategy so that they can meet their ambitious sustainable investment goals. This is a trend we expect to see proliferate.
We don’t claim to be able to time bull or bear markets, shifts from growth to value, large to small caps, or between regions or sectors – and believe anyone who does is likely going to get caught out. However, we do firmly believe in the benefit of active equity management, when you have found truly talented stock pickers and crucially when you own a more balanced and well-constructed portfolio.
More specifically, we are strong believers in high conviction active management, as opposed to quasi active benchmark hugging. By tapping into the top 10 to 20 stocks of multiple managers (say eight to twelve managers in total) we believe you can blend a portfolio together to ensure what you own in aggregate is well diversified and suitably risk controlled across style, country, sector and market cap.
Based on an approach like this, we believe the arguments in favour of increasing active equity investment allocation are now more compelling.
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