By Zeshan Azam, Portfolio Manager, Citi Investment Management
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The return of market volatility should provide active managers the opportunity to apply their stock selection skills once more
Has active investment management had its day? Over the last few years, many active managers have struggled to outperform their equity market benchmarks. Against this backdrop, investors have switched some $1.5 trillion of assets from actively managed strategies into passive investments over the past decade. This shift has prompted some financial commentators to declare the slow death of active management. We, on the other hand, believe such reports to be greatly exaggerated.
There’s no denying that active management’s recent performance has been disappointing. In 2016, for example, just one-fifth of US equity managers beat their benchmark. After fees, the median underperformance was 3%.1 So what might lie behind this? We think the answer lies in market conditions. Equity markets’ generally steady upward march has made it harder for active managers to sort winners from losers. It has also meant little need for the risk management that they aim to provide.
These conditions have also proved advantageous for many passive equity investments. As the markets have trended higher, funds that simply seek to track benchmark performance come into their own. Not only have they delivered returns broadly in line with those of the markets they track, they have typically done so at low cost. Passive strategies’ popularity is particularly clear in markets such as Japan, where they now account for 70% of market share.2
The shift into passive investments has itself impacted market conditions. Blanket buying of all equities in a particular index can cause those securities to become more highly correlated. It can also cause performance to become heavily driven by a small selection of large and influential stocks, as we have seen in the case of the US market and a handful of household name technology stocks. Both of these factors make it harder for active managers to outperform.
While market conditions have been favorable for passive investments – and unfavorable for active strategies – for several years, we do not expect this to last forever. We believe that central banks’ easy monetary policies are the main reason for today’s calm in the markets. But such policies are now being wound down in several countries. And, as the economic cycle matures, history suggests that volatility could return to the markets.
If we are correct and volatility returns, active managers should once again have an opportunity to apply their stock selection and risk management skills. To position for this, we recommend that investors consider including suitable active strategies in their portfolios. The key attributes we would stress in active managers include enduring stock-picking and risk management processes, tax efficiency, customization and access to portfolio managers. Rather than rely exclusively on active or passive strategies, however, we would stress the potential benefits of combining both. Each has an important role to play in creating diversified equity allocations based on a client’s investment objective and risk tolerance.
1 Samson, A. “Active managers tripped up as just 19% beat benchmark”. Financial Times. (2017, January 5 accessed 2017, September 27), web.
2 Hidaka, M. and Fujioka, T. “Japan Central Bank's ETF Shopping Spree Is Becoming a Worry”. Bloomberg.com. (2017, July 17 8:30 PM, Updated on 2017, July 17, 11:01 PM accessed 2017, September 27), web.