The recent challenges of active equity investing – and why this might change
The clouds that have hung over active equity investors for more than a decade are yet to clear. Indeed, ever since Schroders published our paper on the case for active asset management in 2017, the performance of active equity managers has remained lacklustre.
Even in previous bright spots, such as the UK and emerging markets (EM), fewer than half of active managers have beaten their benchmark index. In the US, this has been as difficult as ever (Figure 1). What could explain this uninspiring performance?
How “value factor” exposure has driven active performance
By far the most important driver of the performance of active equity portfolios over the last decade has been the investment style of the manager, most notably the degree to which their process incorporates valuation. Despite the well-documented long-run tendency of cheaper stocks to outperform, value has underperformed growth since the global financial crisis.
Active managers have not always been overweight value. Our analysis shows that following the financial crisis, active managers underweighted value and overweighted growth stocks. In early 2016, managers started to reduce their exposure to growth stocks, most likely because growth stocks were perceived to be expensive. With hindsight, it was too early to discount the potential of growth stocks and to be optimistic on the prospects of value stocks, costing managers in performance.
What could the value-growth dynamic mean for active performance in future?
We have seen a similar story play out before. In the late 1990s and early 2000s, the vast majority of active managers underperformed because of their reluctance to buy speculative technology stocks. The caution paid off handsomely, as value stocks outperformed for several years following the bursting of the dot-com bubble (see Figure 1).
While growth stocks are not as extremely overvalued as they were two decades ago, value stocks are still cheap compared to their recent history (see the full paper for detailed analysis). The large valuation gap means that small changes in expectations could trigger a reversal in relative value-growth performance.
Besides a shift in the implied growth expectations, a related trigger for value-growth performance may also be found in political developments. In our recent paper¹, we show how rising industry concentration in the US has given rise to “superstar” firms that dominate their respective industries. Firms such as Microsoft, Amazon, Google, Apple and Facebook have been able to consolidate their market power and generate abnormal profits and equity returns.
Although investors have benefited greatly from this winner-takes-all market, there is a growing concern that it is harming consumers and worsening income inequality. A tougher regulatory environment poses significant downside risks to superstar firms’ ability to sustain abnormal profit growth.
Regardless of the driver, should the value-growth dynamic shift, active managers would be better placed to capture the potential of undervalued stocks.
What have been the other drivers of active performance?
At an individual stock level, the ability of active managers to add value is determined by cross-stock correlations and the dispersion of stock returns. The former measures the extent to which stock prices move together, the latter the difference in the returns of the best and worst performing stocks. Active managers do best when cross-correlations are low and dispersion is high.
Unfortunately for active managers, the post-global financial crisis period has been characterised by high correlations and low dispersion (Figure 2). Markets have been driven more by broad macroeconomic themes, such as the expectations of central bank easing, and less by future prospects of individual companies. This dearth of opportunities is also evident when looking at the potential return from correctly forecasting earnings, which has more or less halved in the last 10 years¹.
What is the outlook for the drivers of active performance?
We believe that the headwinds described above are cyclical. While it is not easy to forecast cross correlations, dispersion or market breadth precisely, the conditions could be set for a reversal, at least with respect to the latter two. Given that the dispersion of returns increases with uncertainty, active managers tend to do better in challenging times. For example, in 2001 and 2003, and again in 2008 and 2009, the percentage of funds outperforming noticeably increased in the US (Figure 3).
Furthermore, a number of other factors that have led to underperformance of active managers could reverse. In particular, if we see better performance of value stocks and increased differentiation in the prospects of individual companies, active management should reassert its importance in investment portfolios.
You can download the full version of this article: Why investors should not write off active management
1. Source: Schroders, Refinitiv Datastream. Data as at 31 December 2016. Based on Datastream Global Equity Index. Every July we calculate the difference between the actual reported earnings for the following year and the one year forward consensus earnings forecast made at that date. We exclude any companies with negative earnings and companies where the percentage difference is very high or very low (top or bottom 2% of growth). We rank companies from high to low on the percentage difference between the earnings they would go on to report and the forecast earnings at that time. We make an index of the companies in the top quartile of that ranking in each year and compare the performance of the index to the overall universe to estimate alpha.
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