Active management has suffered in recent years as investors increasingly sent their cash into passive strategies, but Willis Towers Watson thinks now is the right time to take another look at stockpicking. 
The move away from active management and towards passive appears to be a long-term trend. While this is most clear in the US market, UK-based investors have also been channelling money into index trackers.
Data from the Investment Association shows tracker funds under management stood at £232bn as of the end of January, accounting for some 17.5 per cent of total industry funds under management.
Global risk management, insurance brokerage and advisory company Willis Towers Watson noted that the strong stock market gains of the past decade – which have seen passive funds beat active in many parts of the world – have “challenged active management to its very core”.
Take global equities as an example. The average fund in the IA Global sector underperformed the MSCI World index in eight of the past 10 calendar years; over the decade to the end of 2019, the average global fund made a total return of 148.79 per cent but the index gained 201.24 per cent.
Performance of global equity funds and index by calendar year
Source: FE Analytics
“At heart, most investors recognise that recent conditions (central bank quantitative easing and low interest rates), while having lasted longer than expected, are unlikely to persist indefinitely,” Willis Towers Watson said.
“But huge flows into passive management and ensuing fee pressure on active managers are all signs that investors have had enough. So why is this? And importantly, why have active managers been left behind?
“The recent trends have caused some to wonder whether active managers still have a role to play in equity portfolios. We’ve taken a hard look at the space and believe now is a good time to consider or even re-consider active equity.”
The firm believes there are three main reasons why active management in equity portfolios is starting to look attractive after its challenging recent past.
Beware of concentration risk
The first factor to be aware of, according to Willis Towers Watson, is the growing concentration risk associated with passive indices.
Many investors believe index trackers offer a ‘safer’ approach than stock picking as they appear to lead more diversified portfolios that the smaller ones built by active managers, but this isn’t entirely accurate.
“The MSCI World index is made up of around 1,600 stocks, so that means its diversified, right?” the firm asked.
“No, the reality is that the top-100 stocks now make up over 40 per cent of the index and it’s these 100 stocks that now dominate performance.”
It added that the problem with this asset concentration is the significant impact that could occur if any of these stocks were to overheat and occupy ever-larger allocations in passive portfolios before crashing.
“It’s not that concentration risk hasn’t caught out the market in the past either,” the consultancy said. “We need only to look back to the so-called ‘Nifty 50’ valuations of the 1960s to 1970s for an example.”
The natural cyclicality of active and passive management
While passive investing has tended to beat active, on the whole, for much of the recent past, Willis Towers Watson said investors need to “resist the urge” to concentrate on recent performance and keep in mind that this could eventually reverse.
“The most recent 10 years’ performance has clearly seen passive strategies dominate over active, as reflected in the decline of the median relative performance of active global equity managers versus the MSCI World index. But could this cycle shift and if so what would the potential implications be?” it said.
“We know the gap between growth and value stocks in the MSCI World index has been prolonged for well over a decade now and has recently become historically wide. Looking at longer data we note that styles go in and out of favour over time and the number of days under the sun (or in the shadows) varies.”
Rolling three-year performance of value vs growth
Source: Willis Towers Watson, MSCI, as at 31 Dec 2019. Each data point is calculated by subtracting the thee-year annualised performance of the MSCI World Growth index from the three-year annualised performance of the MSCI World Value index, at monthly intervals
The consultancy expects that a better environment for stockpickers could be seen in the near future, leading to the potential for “skilled” managers to outperform.
“What drove the market up may well drive it down when the tide turns,” it added.
“The advantage for skilled active managers is that they can be more versatile and respond to changing market conditions more quickly, dodging bumps in the road and working to select the winners (versus the losers) over time. This toolkit will be critical in a sell-off environment.”
The growing importance of sustainable strategies
The final reason why active management might start to look attractive over the long term is the move towards sustainable investing.
Growing numbers of investors in both the professional and private spheres are paying more attention to the environmental, social and governance (ESG) credentials of their asset managers.
Not only does this impact the kinds of stocks that portfolios will include, but how they exercise their shareholder voting rights and engage with underlying companies to bring about positive and progressive change.
This trend has already gained traction in some markets: in the Netherlands, for example, some pension funds are shifting to a more active strategy so they can achieve sustainable investment goals. Willis Towers Watson expects this to “proliferate”.
Given all of the above, the firm concluded that the arguments in favour of increasing active equity allocations are now “more compelling” than they have been for much of the recent past.
“We don’t claim to be able to time bull or bear markets, shifts from growth to value, large to small caps, or between regions or sectors – and believe anyone who does is likely going to get caught out. However, we do firmly believe in the benefit of active equity management, when you have found truly talented stock pickers and crucially when you own a more balanced and well-constructed portfolio,” it finished.
“More specifically, we are strong believers in high conviction active management, as opposed to quasi-active benchmark hugging. By tapping into the top 10 to 20 stocks of multiple managers (say eight to 12 managers in total) we believe you can blend a portfolio together to ensure what you own in aggregate is well diversified and suitably risk-controlled across style, country, sector and market cap.”