Head of Global Equities - Citi Investment Management
Corey Gallagher, Senior Portfolio Manager
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Market conditions have worked against active management in recent years, but this will not last forever.
Should investors seek to outperform their chosen benchmarks via active management or merely try and passively track their returns?
Over the last few years, many active managers have struggled to achieve consistent outperformance. At the same time, passive investment products have become increasingly popular, attracting large inflows from investors. These two facts have led some observers to declare passive investing’s victory over active management. However, we believe this age-old debate is, in fact, far from over.
In our view, a major reason for active management’s underwhelming performance since 2008 has been the intervention of central banks in financial markets. Their quantitative easing (QE) programs have pushed the yields available on cash and bonds to record lows, forcing investors to seek yield and returns in higher-risk asset classes like equities. This has caused correlations between individual stocks, sectors and whole asset classes to rise, making it harder for active managers to distinguish between potential winners and losers based on valuations and other company fundamentals.
Rising correlations amidst QE-fuelled markets have suited passive investing well, by contrast. In equities, broad-based passive strategies indiscriminately buy and sell baskets of stocks irrespective of valuations. But we doubt whether investors really have become agnostic to valuation and other fundamentals and now simply want equity exposure at the lowest possible cost. Just as we think that most investors would not want to ignore a borrower’s credit and employment history before extending a loan, we also reckon they would prefer to know whether assets were trading at a valuation discount or a premium.
Ultimately, we would stress that QE is not eternal. When it does ultimately come to an end, correlations between assets and asset classes ought to decline once more. In such an environment, company fundamentals and valuations should regain a greater influence in driving stock performance. Talented active managers will therefore have an opportunity to bring their selection skills to bear. We think most investors would prefer to buy any asset at a discount and not a premium.
In assessing the performance of active managers against benchmarks meanwhile, we would also stress the importance of taking risk into account. A manager that offers similar returns to other active managers or even to passive strategies but who also takes less risk should be viewed as attractive, provided their fees are reasonable.
A further consideration is the difference between active mutual funds and separately managed accounts (SMAs). The latter have greater flexibility in managing client portfolios and can offer benefits beyond relative returns. One such benefit is the use of tax management techniques, which can be used systematically to limit the impact of taxes upon returns. Another is portfolio customization, where the stocks held are tailored to the client’s particular objectives, perhaps excluding certain stocks or industries.
Just as some of active management’s possible advantages can get overlooked, so can passive investing’s limitations. A significant example of the latter is the lack of potential downside protection. By contrast, active managers can adjust the risk of their portfolios to reflect market conditions, either by increasing cash holdings or by adding stocks that may be better suited to a difficult environment. These possibilities are not open to passive investments, which merely seek to track performance, good or bad.
Once markets revert to more traditional conditions – as we believe they will – investors are likely to focus more upon active management’s potential advantages and also upon passive investing’s limitations. As valuations reassert themselves as the driving force of long-term returns, active managers may therefore find themselves more in favor. In the meantime, though, we think that SMA managers can already justify their fees by providing other services that are not related to relative performance versus a benchmark, including tax efficiency, risk management and customization.