A (POSSIBLY DELUDED) ACTIVE MANAGER SPEAKS OUT
The move from active to passive investing is nothing less than seismic for the asset management industry. In the last ten years passive equity has gone from around a tenth of total equity assets to over a quarter.1 As Chart 1 shows, the momentum in this move seems inexorable.
In this short piece we rehearse what we believe to be the reasons for this shift, which we find compelling, but also offer three thoughts as to why we believe this might not be the time to accelerate the move. In summary, we agree that it makes structural sense to limit one’s exposure to active equity given the breadth of underperformance of active managers and the frictional costs of active management, however, we believe the following:
- Fund alpha is more important later in a market cycle. Historically, at or around market troughs alpha is unlikely to add much to outsized beta expectations. But later in a market cycle, when markets have risen substantially and therefore beta expectations are lower, expected alpha can make a substantial difference and potentially offers a better risk reward.
- The stock-picker’s opportunity set is structurally increasing. We observe that the alpha component of average stock returns has risen in the last few years, having been extremely compressed between 2008 and 2012. We speculate as to why this might be, but conclude with a forecast that alpha’s share of total return is likely to be structurally higher in years to come than it was in the crisis years.
- Smart beta may not be so smart. We believe there should be a threshold level where passive assets become such a large share of total assets that active managers have a better chance of outperformance. This is our most speculative line of argument, and we have no data to support the assertion, but we rely on our intuition.
Chart 1: The Rise of Passive Investing
Source: BAML, Morningstar.
We believe there are many good reasons to invest in passively managed funds, among which are:
About 70% of all equities are still actively managed, down from over 85% ten years ago.1 So, active equity still is the market, and the market cannot beat itself, especially when you consider that active funds are shackled with management fees and other frictional costs of active management. It is no coincidence in our view that the median active manager has underperformed by 1.5% annually over the last ten years, and that the median total expense ratio for active managers has been 5%.
“But what about manager selection? Can’t I pick a great manager who bucks the trend?” (you may ask)
Well yes, maybe, but on average, managers that have historically outperformed for 3-5 years go on to underperform in the following 3-5 years, often because the style that worked in the first period goes out of favor in the second period.
“Ok, but then I could just pick a lot of under-performing managers and watch them outperform over the next period?”
Sadly not. We would argue that managers that underperform either leave the industry or suffer from style-drift and abandon the value or growth strategy that lost them money over the last three years, often becoming growth or value managers just as their newly adopted style goes out of favor. In short, we believe they continue to underperform.
“Ok, but can’t I just look at managers with long track records of outperformance through several cycles and in varying market regimes, and buy them?”
You can look, but you may not be able to touch. These are often closed to new investors, or in some cases their assets have become too large to retain their edge.
As we say, there are many good reasons to go passive, and apparently few reasons to stay active.
“But we know all this and have for ten years, which is why we are all going passive! Why are you wasting my time rehearsing tedious and long-absorbed arguments?”
Good question! We are rehearsing tedious arguments because we believe this may all be about to change.
We contend that the risk premium is now low; that the bond yield is low; so the market beta is low. We further contend that the alpha opportunity is growing; and that therefore the balance between active and passive management is shifting in favor of active management.
So let’s look at our three pushbacks against a purely passive portfolio in more detail.
1. FUND ALPHA IS MORE IMPORTANT LATER IN A MARKET CYCLE.
If you’d had perfect foresight in March 2009 you would have gone 100% long an equity ETF and been done with it, and you would have been absolutely right. But is that such a good strategy now? Assume that you found a great long only manager who you were pretty sure (but by no means certain) could beat the S&P by 300bps a year. Further assume that the S&P was at 667 and your perfect foresight informed you that this was the low. You could just buy your ETF and compound returns at 20% annually for six years, or you could buy the great long only manager and compound at (possibly) 23% for six years. The market’s contribution to your subsequent return is 20% out of 23%, and the manager’s contribution is just 3%. It’s 87% beta and only 13% alpha. And the manager may not perform. Why bother with active equity when the equity beta offers such potential bounty? You wouldn’t.
That was then.
What do you think the risk premium is now, after the S&P has tripled in price since 2009? We think most people would say that it’s somewhere between 2-4%. Add in the bond yield of 2% and your expected total return to US equity in this scenario is in the range of 4-6% per year. So now the picture is rather different. Your manager is still, you hope, going to deliver the 3% expected alpha on top, making your expected return 7-9%. This means that your active manager could now deliver a third to nearly half of your expected return.
Furthermore, if the beta available from passive equity is only 4-6%, we believe this poses a major problem for institutional investors with return targets above that, which they very often are. US Endowments, for example, are required by law to pay out 5% of assets per year to maintain their charitable status. To keep assets fl at in real terms they must achieve returns of 5% plus inflation, i.e. we would assume 6-7% nominal at least. With expected returns in most fixed income markets lower than that, and assuming the equity beta will be below that too, business as usual (65% equity, 35% fixed income and other) won’t cut it.
We believe the picture is changing, and active may be starting to be worth the risk.
2. THE STOCK-PICKER’S OPPORTUNITY SET IS STRUCTURALLY INCREASING
Please consider Chart 2, below. It shows the proportion of total return to the average European stock over the last ten years that is not systematic, i.e. cannot be explained by the stock’s relationship with the market, its sector, its style or its currency of denomination. In other words, it shows how much alpha there is in the average stock. The trendline shows the 12 month rolling average of this. Note that prior to the global financial crisis of 2008, around 60% of return was idiosyncratic. As the crisis hit and as the world absorbed the aftershocks, the alpha share fell to around 30%. However, in the last two years the alpha share has gone up to nearer 40%.
Chart 2: Share of Average Stock Return that is Idiosyncratic
Note: Alpha is calculated as the idiosyncratic return after stripping out systematic factors. Systematic factors considered are style, currency, industry and country. Universe MSCI Europe. Source: Nomura.
We believe (but it’s just an assertion) that these moves in the alpha opportunity set are explained by sensitivity to macro events. Historically, when leverage is high, banks are undercapitalized, ROE is low and the monetary transmission mechanism is broken. Markets are highly sensitive to macro events, notably the actions of central banks and other authorities.
Take the case of the Italian banks (Chart 3, next page). During the 2008-2012 period, what mattered for your stock performance wasn’t whether you were a good Italian bank or a bad Italian bank – its that you were an Italian bank! If macro improved, your stock rallied. If it deteriorated (and it generally did) your stock fell. Since 2012, we observe that there is more dispersion between like stocks. See – for example – the outperformance of Intesa and Mediobanca since ECB Presient Mario Draghi’s “whatever it takes” speech versus the halving of Banca Monte de Paschi di Siena and the rather tepid returns to shareholders of Banca Popolare and Unicredit. Alpha is returning.
3. SMART BETA MAY NOT BE SO SMART.
Our final pushback against a wholesale move into passive equity is that we expect that the more assets are passively managed, the more opportunities for active managers there will be to lean against simple factor exposures. The same criticisms that apply to simple market cap weighted indices (they are price momentum-biased and take no account of valuation) may equally be levelled at a lot of other smart beta strategies. Take minimum volatility strategies for example. These were launched with great fanfare in May 2008 by MSCI (the first on the market), with compelling risk-reward characteristics. And while they have just about kept up with the total return benchmark over time, they have also had long stretches of underperformance. If it was an active manager, we believe you would fire it.
The fi nal problem we see here is that taking money away from active managers still requires an active decision, if you choose smart beta instead of pure index ETFs. That’s because someone still needs to time the factors, for example from value to growth and vice versa, as the market cycle demands. Who is going to do that?
Chart 3: The Return of Dispersion – Italian Banks
Note: Speech by Mario Draghi at the ECB Global Investment Conference, London, July 26 2012: “But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Chart 4: Relative Performance of MSCI USA Minimum Volatility Index TR versus S&P 500 Index TR
Note: Data for MSCI USA Minimum Volatility Index TR is backtested for the period Dec 2004 to Oct 2011. Source: Bloomberg.
To sum up: we believe there are both structural and cyclical reasons to look again at active managers, for whom the opportunity set appears to be increasing as the global fi nancial crisis recedes in the collective memory. The structural reasons are the return of dispersion and the opportunities thrown up by smart beta. The cyclical reason is that late in a market cycle the risk reward of active management improves, assuming that alpha is constant while beta is lower. And now having set ourselves the task, it is up to us to prove these assertions.
1. BAML, Morningstar.