The Case For Active Equity Management by Paul Doyle, Columbia Threadneedle Investments
- The growth of passively managed funds adds to market inefficiency by increasing the prevalence of price indiscriminate buyers and sellers. This can create inefficiencies that active managers can exploit.
- Weakening global liquidity means that there will no longer be a rising tide of liquidity that lifts all boats, and dispersions in the returns offered by individual stocks are likely to increase.
- Active equity managers have added significant value to portfolios in 2015, and this favorable environment should remain in 2016 and the coming years as the era of abnormally low volatility draws to a close.
In recent years, active equity managers have lost market share to passive funds, with some investors questioning the merit of paying active fees when passive funds (and passive ETFs in particular) are cheaper. The relative merits of active and passive ultimately revolve around three key issues:
- The extent to which markets truly are price efficient;
- If they are inefficient, the ability of active managers to consistently and profitably exploit market anomalies, after fees;
- The ability to deliver desired investor outcomes consistently.
The active versus passive debate has usually been framed solely in terms of cost (because active funds are almost always more expensive than passively managed funds). The benefits of active funds – such as long-term engagement with company managements to achieve better outcomes for shareholders and the ability to avoid certain industries altogether when they are performing poorly or face secular or structural headwinds – have been ignored. In this world, cost is king.
The importance of being selective
Arguably, spending a lot of time choosing individual securities does not matter that much if you are a long-term investor, are comfortable with beta (i.e. market-driven) returns with no scope to beat the market, and only care about paying very low fees; the broad sweep of history would suggest that over multi-decade periods, equities outperform cash and bonds.
However, few investors have a multi-decade horizon, and over short and long time periods there are large variations in the returns generated by individual securities, countries and sectors, which can be captured by stock picking. That is why we believe differentiation in our underlying investments – an active approach – is so important.
From our perspective, however, there are other reasons why we do not think a low cost, beta-driven approach is likely to be the most successful approach in a post-QE world:
- Equity markets have performed very well in recent years, and history shows that they do not re-rate forever. Therefore, strategies relying on pure beta alone are unlikely to be as successful in the future as they have been in the past.
- There are major macroeconomic and stock-specific risks arising from the slowdown in China and the associated turmoil in commodities markets. Large-cap mining stocks have been routed this year, as have energy and oil stocks. The effects of this are now being felt by some industrial companies that rely on capital expenditure spending by mining and energy companies to drive their profits. By contrast, high-quality businesses with barriers to entry in areas such as technology and healthcare have performed well, and are likely to continue to do so given the increasing trend towards digitization and aging populations in most of the developed world.
- The “rising tide” of U.S. QE that lifted all boats in prior years has ebbed, meaning that idiosyncratic (i.e. stock-specific) risk will re-emerge as investors pay more attention to valuations and to company fundamentals. Volkswagen and Glencore are just two recent examples. Of course, Japan and the ECB may increase their own liquidity programs in the coming months, which may provide some offset, but global liquidity is driven largely by the U.S. and then China.
- We are in a low-growth, low-return and potentially disinflationary world – partly because the usual process of “creative destruction” that occurs in a recession has not been allowed to take place this time round. As a result, the world is awash with excess capacity in a number of industries. This excess capacity could take years to unwind and will exert downward pressure on company earnings. Companies that can deliver strong earnings growth despite this will trade at a premium and they should make good investments. Moreover, in a low-return world, the “value added” generated by active managers may well end up being a significant component of the total returned that is earned by equity investors, even allowing for investment management fees.
- The focus on fees alone is, in our view, misplaced. To say that one gets what one pays for is oversimplifying the issue, but we think that investors should consider things in terms of: assessing the returns they are getting; understanding how those returns are being generated; over what time horizons; for what level of risk; and at what cost. Only then can investors make informed decisions regarding the relative merits of active and passive investments and their appropriateness to meet specific needs.
- The growth of passively managed funds (many of which track market capitalization indices) adds to market inefficiency by increasing the prevalence of price indiscriminate buyers and price indiscriminate sellers. This can create inefficiencies that active managers can exploit.
While we are not suggesting that all active equity funds can generate strong outperformance, we do feel that to invest in passive funds on the grounds of cost alone means that investors are not considering all the options – and indeed all the potential sources of return – that are open to them.
 ETFs – Exchange-Traded Funds – are essentially low-cost investment funds that can be traded like a share. Most mimic a particular benchmark or index, rather than seeking to beat the market, hence they are referred to as ‘market beta’ strategies (although ‘smart beta’ strategies, which follow specific characteristics that have outperformed in the past, have emerged more recently). ETFs have gained traction compared to passively managed mutual funds because they are tradable (mutual funds are not and have fixed daily valuation points, whereas ETFs are priced in real time). Like passively-managed mutual funds, ETFs generally charge very low management fees.