Is Hope For Active Management Right Around The Corner?
By DailyAlts Staff Investors are looking closely at the role of active management relative to passive investing products such as indexed ETFs, and for good reason: Between March 2009 and the end of 2014, less than one-third of active managers beat the broad stock market’s returns. Why should investors pay management fees for active products that fail to generate positive alpha? Perhaps they shouldn’t, but Neuberger Berman’s Juliana Hadas, CFA, and Andrea Pompili argue that the major factors that have contributed to active managers’ underperformance over the past five years are about to change, and that the investment environment is likely to become much more hospitable to active managers in the very near future. Ms. Hadas and Ms. Pompili make their case in the recently published whitepaper, Can Active Management Make A Combeback? “Post-financial crisis underperformance by active portfolio managers is easily explained and, we believe, only temporary,” they write, before outlining three major fundamental factors suppressing active managers’ returns: Unprecedented central bank stimulus leading to ultra-low interest rates; The magnitude of the bull market in U.S. stocks since 2009; and Flows into passive investment vehicles, such as index ETFs. Ultra-Low Interest Rates Ms. Hadas and Ms. Pompili argue that the Federal Reserve’s policy of keeping benchmark interest rates near 0% have created “valuation distortions in the market.” When companies can borrow at low interest rates, they can finance expansion with debt, rather than with cash flow from operations. What’s more, low interest rates narrow the valuation gulf between near term and more distant cash flows, making further out and more speculative cash flows comparatively more attractive than they would be in a higher interest rate environment. The good news for active managers is that the Fed appears to be preparing for an interest rate hike some time in 2015; quite possibly as early as June. Higher interest rates will result in higher financing costs, thereby sharpening the distinction between firms that have been generating profits with easy money financing, and those that have been generating profits through efficient operations. This discrepancy between companies will make it easier for active managers to beat the broad market’s beta returns, whereas the low level of return dispersion in the U.S. stock market over the past five years has made generating alpha difficult. The Stock Bull Market Since ’09 Low interest rates have helped propel the bull market in stocks since 2009, since low financing costs make it easier for U.S. companies to generate profits. According to Ms. Hadas and Ms. Pompili, 70% of the S&P 500’s returns over the past 20 years have been based on earnings, and with earnings generally easier to come by, there has been a low level of dispersion between U.S. large-cap stocks. Another way low interest rates have contributed to the bull market in stocks has been by suppressing bond yields, and thereby encouraging greater risk-taking by income-oriented investors. Stocks are generally viewed as riskier assets than bonds, and investors are taking on greater risk in the face of bond yields well below 3%. But with interest rates expected to rise later this year, that trend is likely to reverse, which should provide opportunity for active investment managers. Passive Indexing Trends With U.S. large-cap stocks generally trending higher over the past five years, it has been more difficult for active managers to beat the market’s “average” (beta) returns. This is a function of the math: If the S&P 500 returns 30% above the risk-free rate of return, and an active manager had a portfolio with a beta of 0.9, then the portfolio would have to generate more than 3% alpha to outperform the market. But if the S&P 500 only exceeded the risk-free rate by 5%, then an active portfolio would only have to generate a little more than 0.5% alpha to beat the market. In somewhat of a vicious cycle, this mathematical reality has led more investors to dump funds into passive index funds, but these funds are inadvertently momentum investments, since they’re market cap-weighted. Investors buying the SPDR S&P 500 ETF (NYSEARCA: SPY ), for example, buy into all 500 components of the S&P 500 in proportion to their index weightings, without regard to the specifics of each company. Large companies that get even larger end up taking up a greater share of the index. Should the markets turn, and active management delivers, then the trend of migrating to indexed ETFs may slow. Conclusion As Ms. Hadas and Ms. Pompili point out, the performance of active managers versus the broad market’s benchmarks tends to be cyclical and to improve during less exuberant bull markets. Once interest rates begin rising, the “valuation distortions” caused by “aggressive central bank easing” will likely reverse, in the view of the whitepaper’s authors, “creating a market environment in which underlying company fundamentals start to once again matter more.”