Active managers have, on the whole, struggled to outperform their benchmarks over the past seven years, marking a trend that has supported the growth of passive funds.
Commentators attribute this underperformance to rising correlations between markets, which has caused asset classes to rise and fall together at certain points. In addition, there have been higher correlations between stocks – making it harder for stock pickers to generate returns by picking the winners.
“When everything moves together when markets are risk-on or risk-off - as we have seen over the last few years - it is very hard for stock pickers,” said Peter Sleep, senior investment manager at Seven Investment Management.
However, things are starting to change. A new trend is taking hold, which should spell good news for savvy stock pickers. According to analysts at Bernstein, correlations between individual stocks have fallen over the past two months. In theory, this creates opportunities for active fund managers to add value through stock picking.
‘The near term prospects for managers to be able to harvest ‘idiosyncratic alpha’ are as high as they have been in recent memory,’ noted Bernstein quant and macro specialist Ethan Brodie.
Ian Rees, Premier’s head of multi-asset research, agrees there has been a recent shift away from the ‘high sector dispersion’ that previously dominated.
“Over the last two years what we have seen is high sector dispersion within the UK market, but very low intra-sector dispersion. For the last couple of years it has been about what sectors you owned rather than what stocks you owned,” he explained.
It has also been a matter of what sectors you haven’t owned. For example, in 2015 active managers who avoided mining and oil stocks performed well after share prices across both sectors plummeted. However, there was a complete reversal in 2016 – as miners and oil majors rallied when commodities prices recovered.
Has Tracker Outperformance Peaked?
If the recent fall in stock correlations continues, will it allow stock pickers to shine in 2017?
Gary Potter, co-head of BMO Global Asset Management’s multi-manager team, believes this should be the case. In his opinion, we are currently at the “peak of tracker outperformance”.
With this in mind, his team has a low exposure to passive funds, as they expect current market conditions will be supportive for active managers.
“After a period of strong relative performance [for passives] against active funds, normally it is the case that the actives rebound and trackers perform worse in a relative sense. I think that is very much on the cards for this year.
“The direction of travel is one of mean reversion and that would suggest that good active managers should be able to once again add value,” he explained.
Picking The Right Active Funds
However, selectivity when picking funds is crucial in Potter’s opinion.
“Active managers ought to do better this year because the environment is likely to be one of opportunities for those managers. The big question is - have people got the right active managers in their portfolios?
“I would argue that in some cases they have not. They have big unwieldy funds that they think are solid and stable, but those funds are not nimble enough. That is why we have a bias to funds that are less unwieldy, with assets under management in the million mark, not the billions,” said.
In this environment, he expects fund managers at groups like Majedie Asset Management and JO Hambro Capital Management to do well because they are typically flexible and pragmatic in their style. He also highlights Andrew Swan, manager of the Bronze Rated BlackRock Asia fund, as one to watch.
Seven Investment Management’s Sleep points out that active managers have a much better chance of outperforming their benchmarks when share prices are driven by idiosyncratic factors rather than macro events.
“The role of capital markets is to allocate capital to great companies. This is what financial markets should be doing, so I hope they will be more successful,” Sleep added.
While the trend of lower stock correlations appears to be taking root, Sleep warns that macro events could dominate once again, given the raft of oncoming elections across Europe.
Rees echoes these sentiments. In his opinion, active managers will only benefit if there is a sustained period of lower stock correlations.
“I think there needs to be a period of time where stock dispersion picks back up and becomes more elevated for managers to really see the benefit of stock picking coming through in their performance,” he said.
Benefit of Fiscal Policy Shift
Many commentators argue that quantitative easing (QE) has increased correlations as a result of trillions of pounds, dollars, yen and euros being pumped into government bonds to boost stock markets and economies.
If QE is to blame, the situation could soon change because a number of central banks are starting to shift away from monetary policy, in favour of fiscal stimulus.
“If monetary policy winds down and fiscal stimulus picks up, we could see more idiosyncratic risk,” Sleep added.
Each week, Seven Investment Management examines the ‘Kritzman Absorption ratio’. It measures the concentration of risk in portfolios or broader markets, showing when markets are vulnerable to shocks.
Sleep says the ratio is currently low, which suggests that it could be a good time for investors to take on idiosyncratic risk, rather than macro risk in portfolios.
If we continue to see lower correlations between stocks, what does this mean for volatility?
Sleep expects volatility will remain at an asset level, but notes the overall volatility of equity portfolios should fall if the underlying positions are less correlated. “Diversification starts to work again because correlations are lower,” he added.
