By Robert Jasminski & Corey Gallagher,
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Quantitative Easing’s effects on financial markets have made it harder for active equity managers to outperform the market, but skillful managers can still add value for investors.
Robert Jasminski - Head of Global Equities, Citi Investment Management & Corey Gallagher - Senior Portfolio Manager, Citi Investment Management
The goal of active investment management is to beat a particular market. But consistently achieving returns ahead of a given benchmark index is hard, as both practical experience and various studies have highlighted over the years. This is especially true once active managers’ fees are taken into account. According to Standard and Poor’s 2015 SPIVA research, 2007 was the last year where more than half of managers who aim to produce risk-adjusted returns superior to those of the S&P 500 Index actually managed to do so.
Since 2007, less than one-third of active managers have managed to produce returns that beat the S&P 500 Index net of fees. The first three months of 2016 was one of the most difficult quarters for active managers in more than a decade. According to a recent research piece from Bank of America’s quantitative team that analyzed Lipper data*, only 17% of managers beat the S&P 500 Index last quarter.
One possibility is that technology and the availability of timely information are making markets ever more efficient. The more efficient a market is, the harder it becomes to outperform via active management. While there may be an element of this, an even more important factor could be Quantitative Easing (QE). The world’s leading central banks own data show they have created trillions of dollars of new money with which they have bought government bonds in an effort to lower borrowing costs.
These unprecedented flows into financial markets have had a significant impact upon many asset classes. In equities, individual stocks have tended to move more closely together and with less volatility than in the past. With so many stocks moving together, active managers have found it harder to pick potential outperformers. Company fundamentals – the main selection tool for many active managers – have seemingly played a much smaller role in determining returns than central-bank policy.
Could we be witnessing the death of active management and its replacement by passive index tracking? For at least one variety of active management, the future looks bleak. Active managers who claim to pursue an active strategy but are really just charging fees for covertly following the market – so-called ‘closet indexers’ – are likely to suffer further withdrawals in favor of ‘genuine’ active managers and passive trackers.
By contrast, we think the outlook for genuine active managers with proven skill is brighter. By ‘genuine,’ we mean those managers who really do seek to outperform by selecting a different mix of stocks than the benchmark contains. While QE has made it much harder for active managers to achieve this, these unconventional monetary policies will not last forever. When they do come to an end, company fundamentals will likely reassert themselves as among the main drivers of stock prices, potentially allowing active managers to apply their skills to greater effect once more.
We also believe that active management can be valuable to investors during a market downturn. By definition, passive investments that merely track the market do not provide any downside protection against such a downturn. By contrast, active managers may be able to move some of their holdings from equities to cash, and tilt their equity holdings towards defensive stocks or sectors where they identify potential investments that the market may have mispriced. The next sustained market downturn could allow active managers to show their worth once more.
*Bank of America Merrill Lynch US Mutual Fund Performance Update, 4 April 2016