Time for a new era of active management

Active fund managers are, unsurprisingly, in great demand when their returns significantly exceed the benchmark. The trouble is that active managers in aggregate tend to outperform only sporadically and often all at the same time. That is, outperformance most frequently occurs when there are clear market trends due to one or more powerful macro-economic factors, as has been the case for the past couple of years. Active managers jump on the prevailing trends and ride them hard, producing outsized returns for as long as the trends persist.  

But what when there are no clear trends? Then far fewer funds produce positive performance and investors, understandably, look to divest from active funds. They do not invest in active funds for them to deliver returns in some market environments, but then to lose money in the subsequent cycle. Investors seek positive returns across economic cycles and expect fund managers to have the appropriate skills and strategies to achieve this.

The likelihood is that after a volatile period, markets will in 2016-2017 revert to being relatively trendless. It is in this kind of environment that active managers have the opportunity to display their skills and earn the trust of their clients.

Strong trends, strong returns

The direction of the macro-economic environment is not always clear, but the last couple of years have been an exception. Slowing global growth, over-capacity in China and central bank easing have all produced clear market trends that many active fund managers have leveraged.

The clearest market trend is the dramatic downturn in commodities prices, which has led to a sharp fall in the shares of oil and mining companies. Investors have moved in lockstep, selling mining stocks, emerging markets shares and cyclical goods companies. And investors with shorting capabilities have bet against the price of oil and commodities-related companies.

Meanwhile, their long positions have been largely informed by the central banks’ reaction to sub-trend economic growth. Interest rates have been cut across developed markets in order to stimulate demand, leading investors to invest in securities with bond-like returns in order to boost income. These bond-like securities include shares in telecoms companies and other shares which pay above-average dividends.

All change?

When market positioning is extreme, history tells us we can expect a sudden and sharp reversal. This appears to have been underway since the beginning of 2016, with short sellers being “squeezed” as oil and other commodity prices have risen sharply. Particularly in the mining sector, bearish investors have raced to unwind their positions as sentiment has reversed. This fast-moving sector rotation has created volatility and has surprised many investors, creating losses in some portfolios. We believe this is a natural transition period which will unwind the extreme positions that have built up over previous years.

It may take some months for the unwinding process to work through the system. Once it has, markets are likely to settle down to a new rhythm characterised by range-bound markets, which will force many active managers to reassess how they seek to create alpha.

Making money in trendless markets

An absence of extreme positioning is the more normal state of affairs in markets. In trendless markets, the fundamental strengths of companies come to the fore: those with the best fundamentals will beat consensus forecasts and see their share prices rise, while those that fail to beat the consensus will fall away. In other words, there will be less correlation between share prices of companies in similar sectors, and clearer winners and losers.

This environment requires the application of high-conviction stockpicking. High-conviction strategies can unearth true generators of value rather than simply allocating to hot sectors and hoping the sectors in question stay hot.

The next question, of course, is how to find companies that can generate value over the long term and across cycles. Stock markets in Europe are cheap on an historical basis relative to the bond market, but not all companies can outperform in trendless markets. 

Innovation: the key to long-term performance

Innovation, we believe, is the best corporate strategy for creating a competitive advantage and ensuring future growth and profitability. From an investment perspective, innovative companies will outperform those which rely on quality and service. While quality and service are critical business attributes, there are no longer differentiating factors in a highly competitive global marketplace.

Companies that display strong innovative characteristics operate across most sectors, although they are more prevalent in the consumer, industrial, IT, healthcare and specialist chemical segments. It is not necessary to allocate to hot sectors to gain exposure to innovative companies: in the past, investors have overweighted technology companies (in the late 1990s), and energy companies (in the noughties) and have seen prices first soar, then plummet. 

Neither is it necessary to overweight emerging markets in order to seek portfolio growth. Many companies with strong innovation and growth profiles operate in developed market economies, creating new needs and responding to developing ones. Healthy food and drink consumption is one example of a fast-developing trend driven by innovation. Other niche markets are opening up too, with digital innovation mushrooming and long-established market segments such as luxury goods innovating by transferring parts of their business to online platforms.

The resilience of innovation

In the light of the technology meltdown in 2000-2002 and the financial crisis of 2008-2009, investors are keen to create durable portfolios. With worries over the rate of Chinese growth and continued sluggish growth in Europe, many investors are concerned about the possibility of another market crash that could materially impact their financial aims. 

Actively-managed funds that follow hot sectors tend to fare badly in severe downturns. Portfolios of innovative companies, on the other hand, are often more robust. Take the 15% fall in stock markets in January 2016: the fall was unexpected and driven by sudden negative sentiment, leading to correlation between nearly all stocks as their prices fell. Even the best companies lost value.

The difference is that, when sentiment reversed, the share prices of the best (usually the most innovative) companies rebounded almost immediately to their previous levels. This was also the case during and after the financial crisis. Between 2007 and 2009, stock markets lost 65% of their value and Reckitt-Benckiser, a respected and innovative consumer goods company, lost around 10% at its lowest point. However, by summer 2009, Reckitt’s share price was back at its pre-crisis level and more than doubled since then.

Conclusion

A genuinely active investment strategy must have the capability and the aim to deliver positive returns in any market environment. Our high-conviction portfolio is designed to do just that.

Combining high conviction views with a focus on innovative companies - which we believe will deliver superior long-term alpha - means the portfolio has the potential for strong outperformance and robust durability across economic cycles. 

Although the strategy might underperform the benchmark index for short periods when investor sentiment swings towards “hot” sectors, over the medium and long term it should produce significant alpha.