In the age of ETFs, how can active managers outperform?
All industries are cyclical – and investment is no exception. The industry is currently undergoing a marked rotation away from active investment strategies towards passive funds. This is bringing greater scrutiny to active managers, who face growing pressure to justify their prices and performance.
The arguments against active are well rehearsed. The main charge is that active has failed to outperform. Well, of course it has. When active investors make up the bulk of the market – as they still do – it is impossible for all of them to outperform. But the rise of passive means that the market is becoming more momentum-driven through the indiscriminate crowding of capital. That offers greater opportunities for contrarian stock-pickers who recognise this market behaviour and who are prepared to break with trend and the consensus view.
The problem is that too many active managers don’t buck the consensus, but back it. Any assessment of the performance of active managers is clouded by the high number of notionally active investment funds that are in fact passive ‘index-huggers’. Essentially, these offer investors nothing more than an expensive means of accessing the market. One of the main reasons that so many nominally active managers engage in index-hugging is that they are worried about losing investors during periods of short-term underperformance. They’re too scared to do what they’re supposed to do – take appropriate risks on their investors’ behalf.
For contrarian investors, however, the advantage of an active approach is not measured in tracking errors or overweight and underweight allocations, but in the freedom to look closely at those stocks that the market is ignoring.
Why can this lead to outperformance? It all comes back to cycles. If a business is at a low point, its share price will tend to reflect that. The shares will be unloved and out of favour. But many will eventually ride the cycle of recovery as their management turn them around and set them back on course. The best point to invest in such companies is before that recovery gets properly underway. That allows contrarian investors to reap the full benefits of the cycle.
A vital point here is that the best returns don’t necessarily come from the best businesses. Companies that have been doing very well operationally will tend to attract a lot of attention, so their share prices rapidly reflect that success. This leaves limited room for share-price upside. In contrast, investing in companies with considerable room for improvement offers the potential for a bigger turn of the wheel. By the time a company has transformed itself into a market leader, it may well be time to sell.
Pricing is the crucial factor in this. Buying shares in a great company at a high price might seem a good deal. But the potential for market-beating returns is unlikely to be high. If, on the other hand, you pay a low price for a company that is not perceived as great but has significant potential to improve, you are likely to be getting a better deal. Should that improvement come to pass, it will eventually be reflected in the company’s share price. And riding a company’s progress from rock bottom to full recovery is a surer source of outsized returns than assembling a portfolio of market favourites – some of which may be bubbles waiting to burst.
Again, acknowledging the cycle is the key here. That cycle will turn against all businesses in time. So there’s danger in being invested in leading businesses that are at the top of their cycle – especially when those trades are crowded by market consensus. If we look at the technology sector today, we can see examples of extremely high-profile companies that may be approaching their peak. Elevated valuations and popular positions should always be warning signs for contrarian investors.
All of this is easier said than done, of course. It’s lonely at the bottom. To invest in businesses that are at the low point in their cycle, you have to disregard your instincts rather than trust them. That’s because our instincts tell us to herd together. The comfort of the crowd is an inherent part of human nature. But in the stock market, it can lead to overly consensual and crowded trades.
Through patience and persistence, contrarian managers aim to exploit this instinct rather than succumb to it. That not only offers the potential for outperformance as neglected stocks eventually find favour with the market, but also the potential for protection when markets decline. Passive equity strategies offer no protection, of course. Investors should always remember that passive strategies essentially offer ‘market minus costs’. That works well in a bull market – a rising market is what you get, after paying fees. But when markets fall, you get the full downturn with the fees on top.
In contrast, a contrarian strategy that avoids the crowded trades at the top will inevitably be less exposed to the stocks most vulnerable to panic selling. This potential for downside protection is a good argument for combining passive strategies with genuinely active contrarian approaches in a well-balanced portfolio. With many currently concerned about bubbles in the equity market, it’s a timely argument too.
Already, there has been an acknowledgement of the weaknesses of passive strategies through the rise of ‘smart beta’ – alternative approaches such as factor-based investing or equal weighting. But because these strategies don’t seek to replicate the market, they are actually active approaches – and their regular rebalancing entails higher transaction costs than the more traditional passive approach.
It’s too early to say how ‘smart beta’ strategies will perform over the long term. But they will probably also have their place in a well-constructed portfolio, along with passive approaches and genuinely active stock-picking strategies.
Cost remains a key consideration, of course. Bloated cost structures can provide a drag anchor when it comes to fees, but there are fund structures out there that can naturally address this. Funds that are free from the top-heavy group management structures of many large asset-management companies offer clear benefits here. There are also significant advantages to closed-ended funds, which allow their managers to take a longer view and prevent them from being forced to take detrimental action to meet redemptions.
Under the fiercer scrutiny that the rise of passive is bringing, active strategies need to offer something radically different from their passive counterparts. Ultimately, all active managers need to be more contrarian – favouring unloved stocks and looking for undervalued opportunities at the low points in their cycles. This should provide valuable balance to a portfolio, the possibility of downside protection when markets turn sour and the opportunity to outperform through riding the recoveries of out-of-favour shares.
Alasdair McKinnon, ASIP, CFA
30 January 2018
Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.
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