13 November 2017, 14:49 GMT
The past decade has not been pretty for active manager performance.
Active managers, who depend on exploiting on low stock correlations and the difference between stocks, have faced significant headwinds to performance with broad forces dominating markets. Stocks have tended to sell-off or rise in unison, with investors focusing on factors like geopolitics, or the outlook for the economy and monetary policy. The idea of the central bank put, the belief that central banks will backstop markets, has been the animating force of today’s bull market.
Yet active performance looks to have turned a corner in the past year. Close to half of all US large cap managers outperformed the S&P 500 in the year to the end of June 2017, compared to fewer than one in five over the past five years. Low economic volatility has underpinned falling stock correlations, with the global economy enjoying its strongest period of growth since the financial crisis. But is this just a temporary phenomenon, or should investors allocate back to active managers in the hope of better performance going forward?
The outlook for economic growth certainly suggests that stock correlations could remain low, and continue to boost the outperformance potential of active. Every OECD economy is forecast to grow this year, for the first time since 2007. Synchronised global growth usually indicates more robust growth, and while economies like the US are at the late stage of the economic cycle, others like the eurozone are at a much earlier stage, and are benefitting from several years of pent-up demand.
At the same time, the broad forces driving markets are gradually dissipating. With growth strong, central banks are gradually stepping back from markets. The Federal Reserve is poised to stop the reinvestment of its balance sheet while the ECB has announced a reduced volume of asset purchases for 2018. Having made it past the Dutch, French, German and Austrian elections, most European political risks are now behind. While there are still concerns over 2018’s Italian elections or the Catalan situation in Spain, neither represent the kind of systemic risk that has held back the European economy in the recent past.
Falling stock correlations should continue to benefit active managers, but there is also further support if factor correlations fall. These have not fallen to the same extent as stock correlations over the past year, and remain above their post-crisis lows. One reason behind this is the failure of valuation spreads to mean revert, or for the spread between average price of cheap stocks to narrow relative to the average price of expensive stocks. With value opportunities concentrated in sectors like financials and energy, stronger economic growth should allow value stocks to re-rate, as financials benefit from higher loan demand and energy companies from higher oil prices. With valuation spreads remaining high by historic standards, there is significant potential for this to contribute to active outperformance.
Indeed, the only factor which seems unlikely to swing back in favour of active management is momentum. This has traditionally been a strong source of alpha, with it being relatively easy for active managers to exploit the tendency for high performing stocks to keep on winning. With multiple smart beta products now dedicated to targeting momentum as a factor though, active managers must rely on momentum to a far lesser extent.
Providing economic growth remains strong then, it seems reasonable to expect better performance from active managers, and even for a majority to start outperforming their benchmarks. Investors will still need to choose their exposure carefully of course, with this only tipping the scales in favour of active outperformance. But with equity returns likely to be muted after several years of strong beta performance, tactically allocating to active strategies might be a smart move.
Is active manager performance turning around as the influencers of market behaviours start to change as we move towards the end of the cycle
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