Banks’ collapse sparks new active-passive debate
The asset managers presenting to the 2023 Investment Forum event in Cape Town and Johannesburg, early-March 2023, had to make some quick ‘tweaks’ to their presentations as news of the SVB Bank and Signature Bank failures in the US brought back memories of the 2008-9 Global Financial Crisis (GFC). One of the presenters who was anxiously checking market data as he stepped up to the Investment Forum stage was Duncan Artus, Chief Investment Officer at Allan Gray, who set out to answer whether investors rather than central banks needed to ‘pivot’ in response to high inflation and rising interest rates.
Asset management lessons from tennis pros
“Financial markets over the next decade or two are going to be very different from markets of the last 10 to 20 years; and the things that worked in the last 10 to 20 years may not work in the future,” Artus said, before expanding on some of the challenges facing asset allocators in an inflationary, energy short and increasingly divided world. He explained that the difference between an average and great asset manager was not as significant as financial advisers and investors might imagine, using statistics gathered from the world’s top 50 tennis players as proof. It turns out that by increasing the percentage of points won from just 50% to 54%, these players elevated their match win percentage from just over half to 82%. The point is that minor improvements in asset allocation decision making can have a significant impact on return outcomes.
High inflation and rising interest rates have featured at every asset management function this writer has attended through the last quarter of 2022 and first quarter of 2023. And the consensus emerging towards the end of March this year, is that US inflation is likely to settle at a higher than trend level. In other words, that country’s two-decades-long flirtation with 2% or lower inflation is over, soon to be replaced by a new base level at between 3% and 4%. “We are quite used to this level of inflation in emerging markets, but the developed world has not seen inflation rates this high for years,” Artus said. He added that developed market banks were responding to higher inflation by “shrinking” their balance sheets for the first time since before the GFC.
Highly liquid, short duration bonds yielding 6%
What followed was a series of warning about the prospects for developed market equities, especially in the US. The damage caused to US equities by rising interest rates and bond yields over 2022 and year-to-date 2023 is just the early-stage fall-out from banks’ balance sheet rightsizing. “You can be a fund manager with a lot of experience, never having managed funds during a period where central banks’ balance sheets have shrunk,” Artus said, before illustrating the threat to US equities. According to Artus, his fixed income team was able to structure a high-quality, liquid global fixed income portfolio that yielded 6% with short duration to boot. Given that most US endowment and pension funds aim for 7% per annum in US dollar returns, they would be crazy to chase return enhancement from the far riskier equity asset class.
There will still be equity opportunities; but asset managers will have to take care which part of the market they support, while financial advisers and investors may wish to rethink their active versus passive investment strategy views. To illustrate, the presentation included a slide of the top 10 global equities by market capitalisation at the peak of historic stock market bubbles. “It is very, very rare for the same stock to be in the top 10 in the next bull market; if history is any guide [then today’s big tech stocks are unlikely to be] the leaders of the next bull market rally,” said Artus. There are concerns that many offshore portfolios, and especially passive funds or index trackers, are stuffed full of today’s top 10 shares, just as the two-decades-long, lower-for-longer, interest-rate-fuelled equity market ‘bonanza’ looks set to implode. PS, try and beat that series of hyphenated phrases.
Cost of capital impacts investment decisions, return expectations
“The higher cost of capital / interest rates means that lots of things that looked like good investments for a long period of time [turned out to be] nothing but leveraged beta; they were average assets that were geared up because interest rates were low,” said Artus. And then he dropped this bombshell: “The biggest bubble that people are not talking about, and perhaps the least understood, is passive investing”. This writer was certainly intrigued by this comment given the growing popularity of passive investing over the years. The argument goes that money has flooded into index trackers and passive funds due to the favourable equity market environment created by credit creation, quantitative easing and an obsessive, narrow focus on the growth potential in technology shares.
If we accept the notion of ‘super cycles’ in financial markets, then Artus’ assertion that the next decade could favour active investing strategies is plausible. Actively managed funds could make a comeback, scooping up some of the capital flight from index trackers as major developed market indices fall. Unfortunately, South African investors will have to navigate more than the potential shift from passive to active. “The world is splitting in two [and our government seems intent on] aligning with China and Russia,” Artus said. This is “crazy” given how integrated the South African economy is with major Western economies and technologies. The presentation also offered some relevant comment on demographics and environmental, social and governance (ESG) factors as these themes pertain to asset valuations.
On demographics, dolphins and rainforests
On demographics, it was observed that firm’s exposed to the Chinese consumer segment would struggle to maintain their high earnings forecasts due to China’s ageing population. As for ESG, Allan Gray reckons the focus on this theme has peaked. “We want to be a great fund manager that does ESG well; but we do not want you to invest any of your money with us just because we put pictures of dolphins or the Amazon rainforest on our website,” Artus said. He observed that the E, S and G elements making up the theme “traded off against each other”. More importantly, the energy trilemma of clean and affordable energy alongside low carbon emissions was very difficult to solve; hence the emergence of the phrase “just energy transition” in South Africa and many other emerging markets.
Finally, for some ‘shock and awe’, the presentation threw a challenge to the many pro South African equity pundits who had taken to the stage earlier in the day. Upon a closer assessment of “consumer-led South Africa”, Artus said that fund managers had to think carefully about whether they were buying a value trap. The graph that resonated with the audience of financial advisers showed that the country’s industrial production output had flatlined over more than 20-years. In other words, growth in industrial output was entirely due to higher prices, aka inflation. “I shudder to think what would have happened [to the SA economy] if commodity prices had slumped during COVID-19,” Artus concluded. “We would have had no current account surplus; no tax relief; no social grants; and the outlook would have been far worse”.
Writer’s thoughts:
Data from developed markets shows that total assets under management (AUM) in passively managed funds and index trackers now exceed the AUM in active funds. South Africa is slightly behind this trend, but our financial advisers and investors are nowadays exhibiting a growing appetite for passive investments. Is our timing wrong? And are you ready to revisit the active versus passive debate? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
