Passive funds might not save your clients this time around
The major indices in the United States (US) could be in for a slump this coming decade, and investors will have to consider active portfolio management for a realistic chance to outperform the so-called index trackers. This was not an unexpected message from an active manager presentation, but it makes sense given how far and hard US shares have run.
Dependent on great expectations
Matthew Spencer, Head of UK Retail at Orbis Investments, spent 20-odd-minutes at the most recent Allan Gray The Times event to inform his audience of the outlook for the offshore portion of their investment portfolios. “We think the US market is expensive and extended at the moment, and if it is going to keep going up at the rate that it has been, it certainly is Dependent on Great Expectations,” he said, making a play on the widely circulated DOGE acronym.
Spencer offered the five-year return performance on the four Allan Gray funds that your South African clients might favour for their offshore exposure. Returns were initially given in US dollars, ex-fees for a range of time horizons before being restated in rand growth over five years. Your clients would have doubled their cash in the Orbis Global Balanced, and done well in the less-risky Cautious and Optimal funds too. “It is great to see strong absolute returns because that is how you compound your wealth,” he said. The only black mark on the report card was the underperformance (against benchmark) of the manager’s Global Equity offering.
Explaining sub-par returns
Financial advisers take note: the following no nonsense approach could help you explain a mismatch in actual versus expected returns to your clients. Three reasons were offered for the Global Equity fund’s lacklustre showing. First, the companies chosen by the team ended up under-performing the benchmark; second, the method of assembling the portfolio was sub-optimal; and third, the investment backdrop over the last decade or so has made it near impossible for active managers to beat the index.
Your writer enjoyed the detailed reasoning behind each of the points raised. “Throughout our history, only 60% of the companies that we select end up outperforming the benchmark,” Spencer explained. He added that the team had made improvements to address the second issue before sharing a sophisticated portfolio modelling exercise to illustrate how difficult it was to beat US equity benchmarks. Orbis selected a universe of 1500 shares in the MSCI World Index and randomly created 10000 50-stock portfolios from it.
These 10000 portfolios generated returns from 40% (worst) to 190% ( best) over the assessment period. And it turns out that the benchmark would have outperformed 82% of these simulated portfolios. Why? “The Magnificent Seven has made up such a big chunk of the benchmark that if you were not invested in those seven stocks, it was very difficult to keep up as a manager,” Spencer said. Faced with this information, many investors are tempted to go ‘all in’ on passive benchmark trackers, or worse, load up on direct exposure to the large tech shares.
The last decade was different
Through the last business cycle, the benchmark only outperformed 31% of the random portfolios, and through the business cycle before that, when the 1999-2000 tech bubble was unwinding, the benchmark beat a mere 2% of the same random portfolios. “It was certainly frustrating that we were not invested in the Magnificent Seven; but the worst thing we can do now is to compound that error by investing in them at these extended valuations,” Spencer said.
The balance of the presentation was dedicated to share picking in the uncertainty and volatility that defines the US circa 2025. Things have been so crazy over the first quarter that clients have frequently pinged Spencer and his team with a bemused: “What the heck just happened.” There were periods of financial market euphoria when it became clear Donald Trump would be re-elected, and immediately after his inauguration. And there were periods of absolute mayhem, most notably after Nvidia published its earnings, and Trump’s so-called Liberation Day announcement.
Your writer enjoyed the illustration of how fickle major players in the US asset management realm are. Around Trump’s inauguration, Bill Ackman of Pershing Square Capital Management was supportive of Trump’s pro-growth stance; David Solomon, CEO of Goldman Sachs welcomed the news saying, “I am quite optimistic that this administration is going to run a very, very pro-growth agenda”; and Jamie Dimon, CEO of JP Morgan Chase was supportive of policies favouring deregulation and economic growth. But when Trump released his reciprocal tariff ‘hit list’ the main US indices plummeted 10% in just two days, down 18% from previous highs.
An economic nuclear winter
“The US stock market was down, bonds were down, and the currency was down,” lamented Spencer. “We have not seen that in the US market since the end of World War II.” The big money managers quickly reversed their earlier optimism with Ackman slating the administration’s tariff policies, warning they could lead to an economic nuclear winter; Solomon decried that a trade war would be a disaster for the US and the world; and Dimon did a complete 180, saying the tariff plan was “too large, too big, and too aggressive”. It would lead to higher prices and an increased risk of a US recession.
The US markets have since rebounded. The S&P500 was trading near break-even by the end of May, when The Times event took place, and climbed 7% by mid-July. Back in May, Spencer warned that a severe price correction was very possible. “At the current level we are back at square one with the US market trading at extended valuations some 30% above its historical average,” he said. Over the past 15-years, investors in the S&P500 would have received 13% per annum. This rate of return has only been seen three times before, each time in the run-up to a stock market bubble and subsequent correction.
So, with all this noise, what can your clients expect from their US equity exposures over the coming 10-15 years? Orbis approached this question by breaking down the aforementioned 13% per annum return into its components. They identified revenue or sales growth (5.1%); improvements in profit margin or earnings growth (2.6%); changes in valuation through price (3%); and dividends (2.3%) as the main drivers. The next step was to create three scenarios and explore how each of the return drivers might behave. Spencer talked the audience through a bull case, a base case, and a bear case.
The bull case 2025-2039
In the bull case, US companies will be able to maintain their near record valuations, at 25 times PE, and near record profit margins despite the impact of Trump’s economic policies. “In this case, investors can expect 7.1% per annum which is not bad, and certainly better than cash or bonds,” Spencer said. He said the base case, in which profit margins and valuations retreat to the 20-year average was far more likely. If this scenario plays out, you will only see 3.8% per annum from US stocks. And if you want to get really bearish, banking on a fall to 40-year averages, you can expect only 2.3%, which is a negative real return.
Orbis has responded by going underweight US equities across its four offshore funds. However, because US stocks make up around 73% of the MSCI World, they still end up with around 35% exposure to the US. “It is difficult to find value in the US, but if you roll over enough rocks there are a few companies that we are happy to invest our clients’ capital in,” Spencer said. The good news is there are plenty of interesting value opportunities in the world ex-US, including a real estate company in Japan, and a box manufacturer in Ireland. Orbis used the market volatility around Liberation Day to increase portfolio exposures to select shares that over-corrected.
The presentation concluded with an impressive series of slides to illustrate diversification across the asset manager’s funds. You can slice their top 40 holdings by asset class or region or sector or style and still achieve sensible exposure to each underlying metric. Spencer is confident his portfolios will protect investor’s capital and generate return in a range of economic scenarios including dollar weakness and higher than expected inflation. And he delivers this with a low correlation to the top 10 competitor funds.
Beating volatility with diversification
The risk that financial advisers need to manage is that diversifying across five or six highly correlated funds is not true diversification. Because whether the market corrects or runs, each of these correlated funds will deliver similar results. Entering 2025 investors face volatility and expensive US markets with a real chance of a significant market pullback. “The portfolio we have built is different from the benchmark and different from our peers, so it will behave differently, which we think is important in the current environment,” Spencer concluded.
Writer’s thoughts:
Today’s newsletter, based on the most recent Allan Gray’s The Times event, hints that active managers might be a safer bet for client portfolios over the coming decade. Agree, disagree, or is this exactly the message you would expect from an active manager? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
