By Zeshan Azam, Head of Systematic Equities & Senior Portfolio Manager, Citi Investment Management
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The uncertain outlook and spiking volatility have heightened the need for careful security selection. We believe this strengthens the case for including quality active managers in core portfolios.
The worst global pandemic in more than a century has imparted a large shock to the world’s economy and financial markets. The uncertainty has often felt overwhelming, as investors try to gauge the ultimate depth of the current downturn and the likely strength of the subsequent recovery. As a result, US equities suffered their fastest ever sell-off in February and March, with volatility soaring to record levels. Of course, central bank and government intervention have since helped to drive a strong rally in risk assets. However, we believe that hopes of a short and predicable economic downturn may be too optimistic. Our analysis suggests a more volatile road ahead.
How might investors prepare for the more turbulent environment we now expect? While some might be tempted to see risk assets’ sharp rebound of late as an opportunity to sell up and retreat into cash, we strongly advise against such attempts at market timing. Instead, we advocate keeping core investment portfolios fully invested and rebalancing them regularly to keep them aligned to the long-term plan. One approach that we do recommend, however, is considering adding suitable actively managed strategies to core investment portfolios.
For much of the last decade, conditions have not favored active management. A combination of rising markets, low volatility, and narrowing differences between the performances of individual securities made it much harder for active managers to apply their skills. Partly as a result, a large shift out of active managers and into passive managers has occurred. In August 2019, the total amount invested in passive US equity investments exceeded holdings in actively managed funds of the same type for the first time ever.
The environment we now face looks less conducive to passive investing, however. Bigger differences are opening up in companies’ operating conditions. Some have experienced a near-total shutdown of their activities, while others are busier than ever. The effect upon their cash flow will in turn impact their ability to service their debts or return cash to shareholders. Firms with more resilient business models and healthier balance sheets are better placed to survive and prosper amid the uncertainty. Some, however, are at serious risk of financial distress. Passive index-tracking strategies are forced to own both types of company, irrespective of their fundamentals.
By contrast, active managers may have the ability to navigate today’s volatile conditions. Through in-depth research into individual companies, they can tilt their portfolios in favor of higher quality securities while avoiding those that are of lower quality. For example, an active manager may be able to use forward-looking analysis to identify firms that are likelier to sustain their dividend payments, whereas passive yield-seeking strategies might typically use historic – and possibly stale – data to determine the make-up holdings. Notably, some 60% of active large-cap US equity funds beat their benchmark amid February’s market turmoil, the highest proportion since early 2018.
Of course, it is important to remember that not all active managers are made alike. Investors wishing to include suitable active strategies in their core portfolios should seek out those that fulfil several key criteria. Among these are robust and transparent security-selection and risk management processes. They should also include tax efficiency, portfolio customization, and direct access to portfolio managers. We believe that active managers with such features are best placed to navigate the investment challenges and opportunities created by the COVID-19 pandemic and its aftermath.
1 Morningstar, as of 2 April 2020.
2 Bloomberg, as of 8 March 2020.