The acid test of active management
Active managers are more likely to outperform in certain market conditions, but our research finds that there is also a group that can outperform whatever the weather.
All sailors know that there are environmental conditions that affect their performance, notably wind speed and direction, currents and tides. When conditions are ideal, even average sailors tend to do well, as the favourable conditions carry them along. However, when conditions are challenging, only more skilful sailors will be able to outperform.
In the same way, we have found that active managers add more value in particular market environments than others and only truly skilled managers are able to navigate through more challenging waters. Our research suggests that the two key variables that determine these environments are the extent to which share prices tend to move together (known as “correlation”) and, the distance those prices typically travel relative to each other (known as “dispersion”). This makes sense as it should be much easier to distinguish winning stocks from losing ones when the market’s correlation is low and, once a winning stock has been distinguished, the returns for the holder of those stocks should be that much greater if dispersion is high.
We found this theory borne out in practice when we looked at historical records: when market correlations have been low and dispersion of returns high, active managers have performed the best (see first circled bar in chart below). On the other hand, active managers have performed worst when correlation and dispersion were both high (see second circled bar). This environment mostly occurred during the depths of crises, suggesting the average active manager possesses insufficient skill to weed out underperformers when all stocks are falling together. Currently, however, conditions have turned favourable for them as correlation continues to stay low.
Average UK managers' monthly excess returns
The picture changes significantly when we analyse the outperformance of “good” managers1 in the various environments. The main conclusion we reached was that they tend to perform well in all environments. Good managers still do best in the low correlation, high dispersion environment but, contrary to the experience of average managers, they do least well in a high correlation, low dispersion world. This is arguably when their stock selection skills are least effective as the difference in returns between winners and losers is minimal. Contrary to the average manager, the “good” manager does much better in the high correlation, high dispersion environment. This may be because good active managers have enough skill to avoid the worst performers when all prices are falling.
Average UK managers' monthly excess returns
It is worth noting that, although what we have discussed applies to the UK market, the pattern of returns and conclusions are virtually identical for the Japanese market, emerging markets and even those in the US, where active performance has been much maligned.
Our definition of “good” managers so far has been rather like a football league: they are not a fixed group but come and go as their performance promotes them or relegates them to or from the top tier over the period investigated. However, a more practical question is whether it is possible to find a group of active managers who consistently outperform in different environments. We believe it is, and that the knowledge of how managers have performed in different environments in the past can be used as a guide to selecting active managers who are well placed to consistently perform in the future.
To show this, we looked at UK funds that have been able to deliver the most consistent outperformance during both favourable and challenging environments. In each case, we identified the 100 funds that most frequently outperformed. We then looked at how much overlap there was between these lists, i.e. how many of the 100 funds that most persistently outperformed in the favourable environment also featured in the top 100 for the challenging environment. 32 funds passed this test. This suggests that there is a group of skilful fund managers that has been able to persistently outperform its benchmarks in both favourable and challenging conditions.
Why is this important? Because these truly are managers who consistently perform. For instance, we found that these 32 “persistent” managers were able to outperform in consecutive periods more frequently than the average manager. Not only that, the 32 also had a lower chance of consecutive underperformance than other managers.
We don’t want to minimise the difficulties facing investors in identifying good. Our research confirms that when looking at past performance, it is vital to contextualise the performance of those managers in both favourable and challenging environments to gain a true picture. And for anyone who feels they have the skill and expertise to do that, the current environment looks favourable for those few active managers who consistently shine.
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
1. We define the “average” active manager by calculating the average outperformance achieved by all actively managed funds (including those that have failed to survive over time). We define “good” active managers as those able to achieve the top 25% of returns. This theoretical approach would not necessarily reflect the experience an individual investor would have experienced.↩