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Market conditions starting to favour active managers

21 June 2018 Anthony Torr, Stonehage Fleming Investment Management

Market conditions are changing and becoming more favourable for active managers, says Stonehage Fleming, the international family office firm.

Active managers have historically performed better on a relative basis when intra-market correlations are lower, dispersion levels are higher, and market leadership is not excessively concentrated. The first two points are true because they increase the managers’ opportunity set to generate alpha; if all stocks in their index are highly correlated it negates the effects of taking active risk against the benchmark.

Increased concentration of market leadership in itself is not necessarily bad for active managers; the issue becomes more acute when the level of concentration is excessive and when the leadership becomes more persistent, as we have seen more recently in the US as well as in the ‘Nifty Fifty’ environment of the 1960s and 1970s. Examples of where active management has worked despite concentrated market leadership is in European equities, where many managers have been able to outperform their passive benchmarks by investing in high quality consumer and emerging market focused companies and avoiding the large banks and energy companies (this has persisted since the Global Financial Crisis until more recently when the latter group has started to perform better).

The reason for the appeal of larger companies in the years following the Global Financial Crisis had to do with increased investor appetite for higher liquidity; higher quality growth and balance sheets; and higher shareholder returns. The inception of QE programmes injected a mass of liquidity into markets which is easier to deploy in higher versus lower market cap companies. Furthermore, these years were characterised by instability in economic and political fundamentals, which drove investor preferences for higher quality companies with high and sustainable cash flows as well as solid balance sheets. These qualities tend to be more prevalent in larger, more mature companies rather than faster growing but higher risk smaller companies. Economic fundamentals have stabilised in more recent years, which has seen investor focus shift away from more defensive stocks towards large technology companies with higher growth and momentum characteristics.

One of the key drivers of an active manager’s relative performance as well as active risk is not only the stocks held within their index benchmark but also what is not. Active managers as a group have a structural bias towards holding smaller companies relative to a benchmark because these companies are typically less well researched (so have a higher probability of being mispriced), can have higher growth rates relative to their more mature larger company counterparts, and in some cases can have a greater interaction with management given their relatively higher level of ownership.

An example of when active managers have enjoyed a more conducive environment of less concentrated market leadership and better performance of smaller companies more recently was between 2004 and 2006 as the markets came out of the wake of the technology boom and bust of the late 90’s. During this period, the median global equity manager outperformed the MSCI World Index.

Why do we believe that there are signs that the fortunes of the active management industry are likely to see an uptick? Our view stems from two points.

Recently, we have observed that intra-market correlations have been declining and that dispersion levels have been increasing across all major equity markets. This has coincided with investors focusing increasingly on company earnings and the fundamental economic backdrop rather than macro news flow, although volatility from the latter cannot be discounted at any time.

In addition, the reduction of both liquidity from QE programs and involvement from central banks, will likely lead to a reversal of concentrated market leadership and correlations, ultimately providing a better environment for active management.

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