AllianceBernstein's Patrick Rudden says the tide is on the turn for active equity investors.
For years, our best investment advice to clients has been that they should hold diversified portfolios with balanced allocations to stocks, bonds and other assets. But lately it's been an uphill struggle convincing clients of the soundness of this advice, at least where equities are concerned. The reasons are not hard to find.
First, equities have underperformed bonds, and actively managed equities have struggled to beat passively managed ones. Investors of all stripes tend to sell what's done badly and buy what's done well. And, over the last few years, the industry has seen a huge move, totalling hundreds of billions of dollars, out of active equities and into passive equities and bonds.
Second, changes in both accounting rules and regulations have raised the cost of holding equities, causing investors to reduce their allocations.
Third, and perhaps most interesting, the quantity and speed of information keeps accelerating. A decade ago, an investor would have had to wait a few days after month end to see their performance. Now they can get an update at the end of every day and, if they want, every minute and every second. Psychologists have long shown that people tend to manage what they can measure, so it is unsurprising that, as measurement has got quicker, investors have become increasingly short-term in their focus.
It would be interesting to take a step back and consider which of these factors might be cyclical and which are more likely to stay. Performance probably falls into the cyclical camp, as it tends to be mean-reverting – bad performance is often followed by good and vice versa. So, for instance, the fact equities have underperformed bonds for the last 10 years makes it a pretty safe bet that equities will outperform bonds over the next 10 years. Similarly, the fact many typical active managers' strategies have underperformed passive strategies for the last five years means the odds are very good that performance in the next few years will be much better.
Moreover, a swing in the cycle could be imminent. Why am I so confident? Our models suggest equities are very attractive. Whether you look at the so-called equity-risk premium – the extra returns offered by shares over 'risk-free' investments such as government bonds – or the price-to-book ratio – a measure of value – equities look cheap. By the same token, with yields at historically low levels, bonds look expensive (bar some specialist areas such as high yield). All this augurs well for sentiment to swing back in favour of active managers in the near future.
Of course, investors can't ignore those factors on my list that are likely to be permanent. Changes in accounting rules or regulations, for example, are unlikely to be reversed. And given technological developments, it seems highly likely that the quantity and speed of information we all receive is only going to go in one direction, for better or worse.
So any active manager worth his salt these days is trying to help clients deal with risk as well as return. This may take the form of 'insurance' to protect the portfolio from tail risks by using derivatives or counterbalancing portfolios. Or the risk being anticipated may take the form of inflation, when conventional bonds tend to suffer. Active managers can and are putting together portfolios that include assets such as commodities, index-linked bonds and equities, which are able to provide protection against such a general rise in prices. And of course, in their search for good risk-adjusted returns, active managers are exploring new territory, such as emerging markets, and mastering new techniques, such as asset allocation, as multi-asset or diversified growth funds come into vogue.
So while it has been a tough decade for active equity managers, the tide is on the turn. There are plenty of signs out there to suggest now is not the time to give up on either equities or those charged with piloting them. Investors should soon be rewarded, and rewarded handsomely, for their patience.
Patrick Rudden is head of blend equities at AllianceBernstein