Is there a future for active management?
Changing market dynamics have created both challenges and opportunities for active managers.
Investors have long debated the merits of active versus passive management, and questioned which investment approach can best help them achieve their financial goals. This debate has only intensified in recent years as rising sharemarket volatility has created challenges for many active managers to add value.
Exploiting pricing anomalies
The basic premise of active management is that pricing anomalies exist in the market and these can be exploited by investors. As markets are not always efficient, with the right research and methodology, a good manager can identify undervalued securities (or groups of securities that have certain characteristics) to invest in, thereby adding excess return over the performance benchmark. A good manager also needs to be flexible enough to adapt to the changing market environment without compromising its fundamental investment philosophy and/or the integrity of its investment process.
Why has the market been challenging for active managers?
The vast majority of investment managers who seek to outperform domestic and overseas sharemarket indices tend to focus predominantly on selecting stocks they believe are attractive investments based on company fundamentals. This is referred to as ‘bottom-up’ investing. In this framework, ‘top-down’ allocations to countries and sectors is often treated as a by-product of stock selection and their potential impacts on investment performance are often not given sufficient consideration. Since the onset of the global financial crisis, we have seen public sector debt rise, governments cut back on spending, and widespread deleveraging by the private and financial sector. As these events have played out, the correlation between the movement of stocks within industries and countries has increased. This means that price moves have increasingly been driven by investor sentiment towards the economic environment, and less so by individual company fundamentals. In this environment, bottom-up managers have found it hard to outperform the index. As macroeconomic volatility has starts to subside, stock differentiation should regain some of its effectiveness going forward.
The future of active management
Although the prevailing environment has presented additional challenges for active management, it does not mean that active management no longer works. While lower differentiation across individual stocks means that stock selection is less rewarding than it once was, share markets continue to be inefficient, and so the opportunity to exploit these inefficiencies via active management remains.
Active managers are likely to benefit from adopting a more sophisticated approach to portfolio construction and risk management. The ability to navigate the portfolio through an environment where dispersion in performance across countries and sectors remains elevated is also necessary to avoid excessive volatility in short to medium term investment performance.
A greater emphasis on sector and country exposures
It is crucial that active managers understand and are able to manage exposures at the ‘top-down’ portfolio level, or at least are able to neutralise the associated risks of not doing so. ‘Bottom-up’ managers who have placed little emphasis on sector and country exposures will need to keep those exposures close to the benchmark level, and select stocks within those sectors and countries. While this principle appears relatively simple, many active managers have found the adjustment from ‘bottom-up’ to ‘top-down’ challenging as it requires a fundamental change to their investment process.
Flexibility to adopt different investment styles
Investment managers who are quick enough to evolve their investment decisions as the market conditions change will be best placed to add value. In this regard, ‘core’ managers that do not exhibit static style characteristics may be better placed to deliver more consistent performance than their ‘value’ and ‘growth’ counterparts.
The bottom line is that active management will remain relevant for as long as markets remain inefficient. This said, depending on the market environment, some active managers will be more successful than others, depending on their respective skill sets. In sum, investors need to make their choices in the context of their needs and the prevailing environment.