Time to get active again?
As active managers stage a willing comeback, what can we expect in the future? Is this the beginning of a multi-year period of outperformance for stock pickers.
My latest from our US mini mag, sponsored by Thornburg, hitting desks on 12 February.
When Warren Buffett, arguably the greatest living investor, revealed in 2014 that he had advised his wife to invest in low-cost index funds, it appeared the writing was on the wall for traditional active management.
In a frank admission to shareholders that year, he wrote in the Berkshire Hathaway annual letter that ‘the long-term results from this policy [passive investing] will be superior to those obtained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.’
It was a bold claim, although Buffett’s scorn for active managers is hardly anything new. Back in 2007, for instance, he wagered $1 million with fund-of-funds house Protégé Partners that the S&P 500 Index would beat a basket of hedge funds over the coming decade. After a slow start – due to the financial crisis – the index handily beat out the selected hedge funds, returning 7.1% annualized compared to a measly 2.2%.
So, despite his own legendary track record, it seemed Buffett’s bet served to underline a simple point when it came to investing: that after fees, very few managers can beat an index over the long run.
Yet much to the shock of some observers, this trend may now be reversing. With the Federal Reserve (Fed) signalling a gradual end to its accommodative policies, raising rates and shrinking their balance sheet, almost half of U.S. large-cap managers outperformed the S&P Index in the year until June 30, 2017. That is a remarkable turnabout, especially with U.S. large-cap indices among the most scrutinized and efficient in the world.
So what's driving the turnaround? And can it continue into the future?
When beta ruled
To answer these questions, it's best to look at the rise of passive first. It's no secret that the past decade has been one to forget for active managers. In 2016, barely one in three large-cap managers were able to beat the S&P 500 Index, with mid-caps (one in 10) and small-caps (15%) doing worse still, according to S&P Dow Jones Indices. Perhaps even more worryingly, these managers also failed to deliver over longer-term horizons, including 3-, 5-, 10- and 15-year spans.
Predictably, many investors have flocked to cheaper passive products. Not only do index funds already account for over 30% of the U.S. equity market, but ratings agency Moody’s Investors Service reckons this could climb to more than half by 2024.
‘Most professional managers have been wrong-footed by events in recent years, be it the Trump election, Brexit, the botched Fed hike in late 2015 or the Chinese devaluation in August 2015'
‘Most professional managers have been wrong-footed by events in recent years, be it the Trump election, Brexit, the botched Fed hike in late 2015 or the Chinese devaluation in August 2015,’ notes Vincent Deluard, global macro strategist at INTL FCStone Financial, a Nasdaq-listed financial services company.
Beyond this, though, there are other causes that are less well understood. Whereas the conventional narrative holds that there's overabundance of active managers, most of which don’t make the grade, this fails to tell the full story. Instead, excess liquidity, lax credit conditions, rampant share buybacks, and the rise of passive investing itself have contributed to stunning returns of passive investing – all at the expense of active.
A case in point is the remarkable correlation between the Fed’s balance sheet and stock returns.
Fed balance sheet vs S&P. Source: Federal Reserve St Louis
Why is this? Because when interest rates are kept at record lows “there is no alternative” to buying shares (TINA), and companies of all stripes, no matter what shape their fundamentals are in, can catch a bid. In other words, this TINA rally helped lift all boats – especially as low-cost Exchange Traded Funds (ETFs0 became more popular – while stock correlations neared record highs and price discovery grew less important.
Similarly, record-low interest rates saw U.S. companies engage in financial engineering, refinance debts at much lower rates, and borrow money for share buybacks. Between 2009 and 2016, for example, it’s estimated that a shocking 40% of earnings-per-share growth and a full 30% of U.S. stock market gains were a result of share buybacks, with total buybacks in 2016 the second largest in history, according to Artemis Capital Management.
‘Share buybacks are a form of financial alchemy that use balance sheet leverage to reduce liquidity generating the illusion of growth,’ wrote Christopher Cole, the founder of Dallas-based volatility hedge fund in a paper late last year. ‘Absent this financial engineering we would already be in an earnings recession.’
Share buybacks act as driving force. Source: Dentresearch
Moreover, companies’ indiscriminately buying any selloffs crushed market volatility as major drawdowns became a thing of the past. The result: valuations were nearing record highs, volatility was plumbing record lows, and stock indices such as the S&P 500 enjoyed Sharpe Ratios approaching 3.5 – an astonishing number that few managers, if any, could hope to achieve. All in all, passive investing enjoyed its best risk-adjusted returns ever.
This low volatility melt-up has had harmful knock-on effects on active managers, Deluard warns. ‘First, the switch to active mutual funds to ETFs is not neutral. Because ETFs hold much less cash, the rotation creates addition demand for stocks.’ Deluard estimates that the rotation from active equity funds to ETFs has resulted in net extra buying of $40 billion.
‘Second, competition from ETFs has changed the behaviour of large active funds,’ he adds. ‘Because of investors’ fickleness, even star managers cannot afford a bad quarter. Since most mutual fund companies rely on a handful of well-established funds to pay the bills, flagship funds hug their benchmark to preserve their ratings.’
'Because of investors’ fickleness, even star managers cannot afford a bad quarter. Since most mutual fund companies rely on a handful of well-established funds to pay the bills, flagship funds hug their benchmark to preserve their ratings'
The figures are alarming. In 2017, Deluard and his firm found that the average U.S. active manager currently keeps his fund's beta between 0.9 and 1.1, versus a much wider dispersion in the past. Put simply, active managers are actually becoming less active in their approach, worried their returns will underperform their benchmark by too much if they’re too contrarian.
Lastly, regulations have dealt a major blow to active too. ‘Embedded in the Department of Labor Fiduciary Rule and Europe's Mifid 2 regulation is an effort to move broker-dealers and investment advisors assets into cheap index funds,’ Deluard says. ‘Fees and commissions are seen as inherently suspicious (which they often are), rather than the counterparty for a valuable service (they sometimes are).’
Trend reversals: Less beta, more alpha
Fortunately, these trends are now reversing, giving active managers a new wind. Now aided by much-needed fiscal stimulus and heartened by better-than-expected growth, the Fed seems determined to tighten monetary policy further.
While the board’s governors will take great precaution in unwinding its bloated balance sheet, three rate hikes are now expected in 2018; Goldman Sachs and others think we could see more if inflation surprises.
Source: Bloomberg
That will aid stock pickers. Last year, Morgan Stanley estimated that rolling correlations between stocks within the S&P 500 was around 18%, its lowest level since 2004 and far below the 60% recorded in 2016. Further rate hikes should keep this trend going, as companies are rewarded on their fundamentals, rather than easy monetary policy and the explosion of passive investing. For the first time in years, price discovery is making a real comeback.
‘I think that the fall in correlations, which you could attribute to less central bank stimulus, is probably the biggest driver of active managers’ reversal in fortunes,' French-born Deluard exclaims. ‘Stock picking works again.’
While large share buybacks are expected once again this year as a result of President Trump’s tax cuts and subsequent repatriations, they seem unlikely to persist. Crucially, credit conditions are slowly beginning to turn, forcing firms to become more prudent; share buybacks fell dramatically last year, for example.
And instead of blindly buying dips, some firms may actually begin put their hard earned revenue to R&D and investment if the long-term economic picture begins to brighten.
This, in turn, may seem people begin to trust active managers once more, and the less pronounced the effects of passive investing – such as the erosion of price discovery and index hugging – will become.
‘If you’re going to pay fees, you may as well pay someone who is at least trying to beat the market,’ Deluard says. ‘I believe a manager that does hard research work instead of hugging the benchmark has a better chance of success in a less efficient market, with more ‘suckers’ to trade against.’
A fresh beginning for active?
With tailwinds for active managers now picking up, what does the future hold? Here, it’s worth looking at history according to Mark Yusko, founder and chief investment officer of Morgan Creek Capital, a Chapel Hill-based long-short equity hedge fund.
Speaking late last year, the former Tiger Management alumni was quick to point out that investing remains a cyclical business, with mean reversion a constant thread. ‘One of the things that gets lost when one style begins to dominate, is the recency bias many people have,’ he noted. ‘They think that because long only or index funds have beaten their peers over the past seven years that they always will.’
'We know that over the last 40 years active management has outperformed about half of and passive has outperformed about half the time.’
‘But we know that’s not true,’ he added. ‘We know that over the last 40 years active management has outperformed about half of and passive has outperformed about half the time.’
Digging deeper, Yusko pointed out that if you look at a large cap index in depth, you’ll see they’re essentially momentum plays, since they rebalance themselves so frequently; the S&P has replaced 85% of its names over the last 30 years, dropping all the underperformers that may weigh it down.
‘Momentum strategies work very well when central banks expand their policy,’ he said, ‘such as the past seven or eight years. So it’s no surprise that index funds came back to win the Buffet bet, even though Warren was behind for the first five years as a result of the financial crisis.’
Yet these same momentum plays tends to lag value and other more active strategies when stimulus is removed, which bodes well for traditional managers in the coming few years. This is also why so many investors and asset allocaters have been calling for a return of value investing, after a decade-long hiatus.
What’s more, the lofty valuations of the US stock market mean future returns are likely to be poor going forward, highlighting the need for a highly selective approach – and perhaps more cash.
As Vitali Kalesnik, head of equity research at Research Affiliates, said in January: ‘The US market today looks pretty expensive; the CAPE ratio… today is at levels only seen in 1929 and during the tech bubble.’
Unfortunately for investors, ‘there is very strong evidence in the United States that it forecasts subsequent returns, which will be low.’
Yusko concurred with this dour forecast. ‘I think we’re at a very, very important juncture when people who buy into the index today are going to suffer very negative returns over the next decade, just as they did in 2000, the last time when value was supposedly dead and hedge funds were dead.’
And as idiosyncratic opportunities emerge and active managers are proved to show their worth – through concepts like active share – we could see a greater return divergences, driving more alpha in the coming years.
The improving backdrop was enough to prompt Yusko to offer Buffett the same $1 million bet over the next decade. Buffett, now approaching his 90s, politely declined – although he said he was confident that the S&P 500 will outperform active.
‘The current everything bubble is going to end very badly,’ Yusko responded. ‘If he really believes that passive will win out, then he should make the bet with me.’