Where should you invest if you believe active management can outperform?
• Demand for concentrated strategies is increasing as smart beta forces active equity managers to focus on alpha delivery
• The trend could result in more mandates per pension portfolio
• Decreased equity correlation has spurred active equity performance
• Long-term market cycles and mean reversion are likely to support active management
• The equity risk premium may remain the major contributor to portfolio performance
Long-suffering active equity managers may see added interest in their products in 2018. But the revival will likely remain limited to those managers who can demonstrate that their strategies have been able to deliver performance in excess of the relevant benchmark.
Consultants say investors considering adding to active equity exposure should focus on concentrated strategies that express a manager’s investment philosophy and process through holdings in a limited number of companies, and in general look to those styles in which research has identified a sustainable performance premium for active management, or where factors have created valuation disparities.
“The big trend [for 2018] we see among our clients at institutional plans globally that are looking at active equity is one of seeking concentration,” says Fabio Cecutto, head of focused equities at Willis Towers Watson in London. “The premise is, if you are seeking to deploy an active equity mandate, there’s the expectation that a concentrated manager, predominantly from a stock-picking firm, can add some value,” he says.
It’s more than an academic exercise. “We see an increased appetite for really getting the manager to deliver,” Cecutto says. The active management industry has struggled to exceed benchmark performance, especially after fees, in large part due to over-diversification, he explains. That has sparked demand for strategies that zero in on an alpha source. “To allow the manager to best express his views with conviction, leads to portfolios that are either concentrated by the number of stocks, so fewer stocks in a portfolio with higher weights, or by having a portfolio that looks very different from the benchmark, whether in terms of sector position, stock position, or geographic dispersions,” he says.
The value proposition is clear. “If you are skilled in thinking, a concentrated portfolio will provide better evidence of your skill and better risk-adjusted returns,” Cecutto says. In practical terms, he adds, a focus on concentrated active equity strategies is likely to produce a portfolio with more managers, perhaps eight to 10 managing targeted strategies with as few as 20 holdings, compared to four managers running diversified strategies of 80 stocks. Investors must also ensure managers have the process and behavioural temperament to run concentrated strategies, Cecutto says, while carefully combining managers to maintain the desired risk-reward balance. “A concentrated portfolio is a beautiful thing if the managers have skill,” he says. “But the more you concentrate, the more every single stock becomes like a torpedo in your portfolio.”
Just as US crook Willie Sutton infamously robbed banks “because that is where the money is”, so should institutional investors look for active strategies in areas where alpha is known to linger.
“We consistently have seen an active premium within the small-cap universe, both small-cap value and small-cap growth,” says Mark Wood, vice-president and US equity investment consultant at Callan Associates in San Francisco. “The small-cap premium has been well documented, and we’ve seen the ability for active managers to add relative value over their underlying benchmark.” That has also attracted competition, and “the premium has diminished over time as quantitative managers passively manage assets in the sector”.
But structural components of the small-cap premium remain in place, Wood says. Many stocks are less covered by research analysts, managers have a larger universe to choose from, and despite the recent influx of passive capital, there has been “less uptake” of small-cap equities by passive managers. “It’s an area where we continue to see potential opportunities for active managers,” Wood says.
Wood cautions against seeking to enhance returns by tilting a portfolio towards growth or value. “Growth has outperformed value over recent intermittent periods pretty precipitously, so mean reversion would say that value is poised to outperform at some point,” says Wood. But calling an inflection point is difficult. “We don’t take the tactical factor bet, per se, on value or growth,” Wood adds. “We think it’s a good diversifier to have separate active managers seeking that premium out.”
In 2018, Wood says, active equity investors “may benefit from diversification given how big the spread has been between growth and value.” That said, foregoing strong returns in mean-reverting sectors in order to maintain a diversified allocation can have a cost. “Diversification can hurt in the short term,” Wood says. “But diversification helps when you least expect it to.”
What will work in 2018?
Mean reversion may turn out to be an important driver of active equity returns in 2018. The most recent positive performance by active equity managers has been attributed to the creation of more opportunities for managers to pick winning stocks as the correlation between equities decreased during 2017.
But that conventional wisdom might be confusing cause and effect, says, Nick Samuels, director of manager research at the consultancy Redington in London. That case is often put forward by active equity managers, Samuels cautions. There remains a question about whether reduced correlations attract new capital flows to equities as stocks diverge, or whether differential capital flows into individual equities cause changes in the relative performance of the companies, which last show up in aggregate market data as reduced correlation.
While there is some validity to the notion that wider performance dispersion can allow active managers to demonstrate their ability to select superior companies, Samuels counsels investors to maintain a long-term outlook. Ultimately, “I place more faith in market cycles and mean reversion,” he says. “Nothing grows to the sky.”
For 2018, Samuels says active strategies in emerging-market value equity and Japanese small caps with a value bias are two areas that will offer an opportunity. Emerging-market value equity strategies lagged in 2017 owing to the surge in growth tech names like Tencent and Alibaba that value managers typically do not own. “That doesn’t feel like something that can go on forever,” Samuels says.
Similarly, in Japan, capital has flowed into growth-oriented higher-quality stocks, in part through the Bank of Japan’s exchange-traded fund purchases as part of its accommodative policy. “You have a quite interesting opportunity in Japanese value, and the mid- and small-caps are not widely covered,” Samuels says. “We did quite a bit of work on that, and believe there is some decent alpha down the cap scale in Japan at some point.”
Projecting equity market performance is difficult. Historically, it is only when the economy shows signs of overheating and monetary policy becomes restrictive late in an economic cycle that equity markets begin to falter, according to John Bilton, global head of multi-asset strategy at JP Morgan Asset Management. Bilton says: “The notion that a late-cycle economy is one slip from a contraction is not borne out by history. Late-cycle phases last on average around two years, and if policy remains supportive, it can last a good deal longer.”
Clearly, equities will remain a workhorse for pension investors. “We believe in the equity risk premium,” says Wood. “Equities continue to have a premium over fixed-income assets, so they are probably going to be the biggest contributor going forward for a portfolio.”
While not making a forecast, Wood notes that since 1980 the S&P 500 has posted gains in 79% of all years by a median of 12%, with an intra-year drawdown of 11%.
Based on economic indicators and earnings late last year, Wood suggests a more reasonable expectation for US equities might be low-to-mid-single digits. “Unfortunately,” he says, “anything more refined than that is pure speculation.”