By Zeshan Azam, Portfolio Manager, Citi Investment Management
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The case for active management will be clear if volatility makes a comeback
As the bull market in US equities continues to mature, volatility has reached historic lows. Positive returns and falling volatility have led to an increase in the aggregate market’s Sharpe ratio1 – the industry standard measure of risk-adjusted returns – over recent years. The S&P 500’s Sharpe ratio has almost doubled compared to the period before the financial crisis – figure 1.
Source: CIM as of 30 November 2017
In this environment of rising markets and falling volatility, an increasing number of investors have shifted to passive investments from active strategies. As we wrote previously in The outlook for active management, lower fees are often seen as the primary attraction of passive investments. However, active managers offer participation in rising markets but with potentially better downside protection. We believe this is a valid reason to reconsider active management, particularly as the bull market may enter its tenth year in 2018.
As the equity market has continued rising with limited dispersion of returns among individual stocks – leading to an increasing Sharpe ratio – some investors seem to believe that these helpful conditions will last forever. However, volatility is likely to make a comeback at some point. And the value of active risk management is never fully appreciated until something goes awry in markets. Active management has always been cyclical and active manager performance will come back given the right conditions.
Our base case is not for equities to exhibit extreme volatility in the near-term. However, in the event that we do see market volatility return, we believe actively managed portfolios can position themselves to weather such a storm. It is important to have a robust investment process incorporating risk controls in every step – from stock selection, to portfolio construction, to tactical positioning. Investors should consider a strategy that has potential downside protection and lower volatility relative to the market for strong risk management over the long term.
1Sharpe ratio = (Mean portfolio return - Risk-free rate)/Standard deviation of portfolio return. For simplicity sake, we use zero as the risk-free rate to circulate the Sharpe ratio. Zero offers a conservative take on the Sharpe ratio as risk-free rates were higher pre-financial crisis, therefore implying a lower Sharpe ratio in comparison to the post-financial crisis period.