Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Joe Amato, President and Chief Investment Officer of Equities at Neuberger Berman, looks at how active managers are making a comeback as correlations collapse.
Over recent months, we have noted how the economic and investing environment has regressed to the 'Goldilocks' mix of slow-but-steady growth, low inflation, low rates and low market volatility that characterised the pre-Trump era.
Small caps are underperforming large caps, value stocks are underperforming growth stocks and the 10-year Treasury yield has edged closer and closer to the 2% threshold. It is all very 2015 – with one important difference.
Stock Picking Paying Off
Active management has been paying off. According to data from Morningstar, only 26% of active US stock funds beat composite passive benchmarks during 2016. Over the 12 months through to July 2017, however, 49% outperformed. Long/short equity hedge funds are also enjoying an excellent year. These results are net of all fees and transaction costs.
One of the reasons stock picking is making more of a difference for investors now is that correlation between stocks has collapsed. In the S&P 500, for example, correlation has gone from almost 70% at the beginning of 2016 to less than 30% today. Despite market-level volatility being very low, we are seeing rather high single-stock volatility and significant sector rotations.
The fundamental reason underlying this market behaviour is that, for the first time since the financial crisis, the capital allocation process is being driven by company-specific factors, rather than the macroeconomic factors that have prevailed over recent years – as well as the extreme 'risk-on, risk-off' approach investors adopted to navigate that environment.
The results have manifested as the delivery of meaningful excess returns versus the various market benchmarks over the last few months – a timely reminder after many months of headlines pronouncing the demise of active management in the face of a seemingly unstoppable flow of funds into passive vehicles – that these performance trends have been cyclical rather than structural.
The Long Trend Favouring Passives
How often did we hear the active management model was broken entirely, or, at best, only capable of outperforming in bear markets, or reliant on the systematic premia paid to holders of small-cap or value stocks? Recent outperformance by a growing proportion of managers, against a grinding bull market powered by large-cap growth stocks, lends support to the idea talented stock pickers can outperform in a variety of conditions, as long as there is a willingness through the rest of the market to allocate capital in accordance with fundamental, company-specific views.
With that in mind, the recent long trend in favour of passives is understandable given the macro-level risks that have overshadowed markets since the financial crisis – from the threat to the integrity of the euro, through the brinkmanship around the US debt ceiling, to the constant background noise of quantitative easing and zero interest rates.
While these dynamics have not gone away entirely, there would always come a time when a critical mass of market participants became inured to them, and looked beyond them for information. We may have passed this threshold over the past 12 months, as central banks began to talk of reducing balance sheets and 'animal spirits' have been roused among corporate management around the world.
Are We at an Inflection Point?
If so, this could be one of those inflection points that remind us that the seeds for outperformance by active managers may be sown while the market allocates its capital in ways that are divorced from company specifics or fundamental economic themes. They also remind us that, among the compelling reasons to invest only part of a portfolio passively, one is to create the flexibility to take genuine active risk elsewhere, with strategies that exhibit high levels of active share and single-stock conviction.
Abandoning active management can forego the opportunity to generate excess returns, as the stock pickers’ comeback of the past nine months has shown.
Disclaimer
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