The end of quantitative easing and rising rates could signal the end of correlated markets and the opportunity for active management to start shining, according to GAM’s head of equities Matthew Beesley.
One of the biggest challenges for active asset managers in recent years has been the increasing popularity of passive strategies.
Flows into passive strategies have been inching up in recent years, as retail investors have sought out low-cost funds capable of tracking markets more efficiently.
Active and passive as a proportion of total UK AUM 2007-2016
Source: The Investment Association
The most recent figures show that funds under management in tracker funds stood at £159bn at the end of August, representing 13.7 per cent of total industry funds compared with 12.8 per cent a year earlier.
Last year was a difficult one for active managers to outperform as many were caught out by an extreme swing in investment styles and geopolitical challenges, such as the majority vote for Brexit and the election of Donald Trump as US president.
More significantly, the advent of quantitative easing since the global financial crisis has had a distorting impact on markets, making active management challenging.
“The market environment has certainly been challenging for active managers in recent years, with the advent of quantitative easing [QE] across much of the developed world aggressively distorting equity markets,” said Beesley.
“Earnings growth has been low as the world has recovered from the bust of 2008, while asset price inflation has been high.
“With interest rates low globally, correlations between assets and also within asset classes have been high which has led to a challenging period for active management.
“More importantly with correlations high, it has been harder for fund buyers and selectors to differentiate between good and bad asset managers.”
However, Beesley said with the end of QE approaching and the prospect of rising interest rates, investors have once again begun to focus on active management.
Indeed, the macroeconomic backdrop for equity market has already begun to change, he said, highlighting rate increases and the proposed removal of stimulus programmes.
“We expect stock correlations to continue to fall and dispersions of returns to rise,” Beesley said.
“Low correlations between individual stocks and a high dispersion of returns between the best and worst stocks within a sector – known as cross-sectional volatility – create a fertile environment for an active stock-picker with a clear and consistent investment process.”
He added: “With markets having risen so strongly from their lows in recent years, we should also be aware that dispersion can be amplified by market direction.
“Put simply, when market downturns occur, this is when dispersion increases the most and active managers add the most value.
“We are now eight years into this current equity bull run. There will be a time soon when active managers really prove their worth to the discerning client.”
Beesley further noted that some markets are also less efficiently valued than others, presenting some “substantial and persistent” opportunities for active stock selection.
Although there is a “raft of research” demonstrating that the average active fund underperforms its benchmark net of all fees, said Beesley, there were some “clear reasons” why.
As the below chart from last year’s interim report of the Financial Conduct Authority’s Asset Management Market Study shows, an investor in a typical low-cost passive fund would earn 24.8 per cent more on a £20,000 investment than an investor in a typical active fund, assuming returns for both strategies were the same as the FTSE All Share index.
Returns on a £20,000 equity fund over 20yrs assuming average FTSE All Share growth
Source: Financial Conduct Authority
Beesley said: “The really important point is that a large number of managers align their portfolios so closely to the benchmark index that they make it difficult to outperform on a net-of-fees basis.
“For example, a fund with a tracking error of 3 per cent and a total expense ratio of 1.5 per cent can only deliver net relative performance in the range of -4.5 per cent to 1.5 per cent.
“In other words, the chance of underperforming the benchmark over any randomly selected period is three times that of outperforming.”
Active share has been suggested as a useful guide for differentiating between so-called ‘closet trackers’ and genuine active funds, said Beesley, noting another study highlighting the drop off in active share.
“This dynamic probably reflects a greater fear of materially underperforming the benchmark than an ambition to outperform,” he said.
“The irony is that, in pursuing such a ‘safety first’ approach, closet indexers have effectively advanced the case for passive management, which otherwise would probably not have been viewed as such a compelling alternative.”
Beesley added: “In essence, every single index tracker pursues a capitalisation-biased, long momentum strategy.
“This means that, by definition, they buy high, sell low and passively contribute to the inflation and bursting of asset bubbles. The same can be said of closet indexers.
“Conversely, truly active managers are ideally placed to exploit the valuation anomalies created by the indiscriminate buying and selling of the capitalisation-weighted market.”