The recent market downturn
had negative consequences
for many investors’
portfolios. In an environment
marked by severe
macroeconomic stress and
unprecedented volatility,
both actively and passively
managed investment
strategies suffered. After
a year of undifferentiated
performance, some investors
are revisiting the debate
surrounding the merits
of active versus passive
investing styles.
Active and passive portfolio managers approach investing from different perspectives. Passive strategies such as index funds attempt to mimic the returns of the market. Active managers believe there is value in being different and seek ways to deliver that value to investors. Passive strategies attract investors with low fees and - when the market is performing well - market-like returns. During a downturn, the value of passive portfolios fall in sync with the market.
Looking at the active-passive debate from a purely performance perspective, we believe the current macroeconomic and market environments look positive for active managers with strong stockpicking capabilities.
The case for active investing
Individual investors typically choose active portfolio managers to outperform the market, particularly on the downside. In a bull market, active and passive strategies alike can succeed. Outperformance often becomes less of a concern. This is not the case in a down market.
While passive strategies are often constrained by investment policy to remain fully invested, active managers may be able to protect on the downside by repositioning a portfolio in favour of more defensive stocks or holding higher cash levels until investment conditions improve. Successful downside protection also improves average portfolio returns over a full cycle by shortening the path back to a break-even point.
The value of active management extends beyond the possibility of downside protection. Active managers have an opportunity to outperform the market. While passive managers usually merely seek to mirror a benchmark in terms of sector weights and security selection, active managers can take a wider view, looking for ways to add value. From the portfolio level down to the security level, active managers often have a number of tools to help achieve attractive returns. These include asset allocation, sector rotation and security selection.
Asset allocation
An active equity manager has the option to move from a portfolio that is fully invested in equities to one that incorporates a percentage of cash. In a declining market, cash provides a safe haven, helping a manager ride out a downturn while positioning the portfolio to take advantage of opportunities as they arise. In the down market we recently experienced, higher cash levels helped many active equity managers produce milder declines and lower volatility than their benchmarks. In a strongly positive market, equity managers can revert to a more fully invested model, helping them keep pace and potentially outperform as the index rises.
Sector rotation
Passive managers tend to mirror their benchmark sector allocations, leading to a few potential issues. First, as certain sectors out- or underperform, their weightings within the index change, leading to imbalances within passively managed portfolios. This was the case during the tech boom of the late 1990s. Many indexes were overweight technology due to relative outperformance of stocks within the sector. When the market turned, tech stocks took the biggest hit, leading to a steeper decline for passive index managers. Passive portfolios are constrained in their ability to look forward and may not be best positioned to take advantage of opportunities in the market. Active managers are often able to rebalance sector weights when performance leads to outsized allocations, and can more heavily weight or avoid sectors based on future performance expectations.
Security selection
Stockpicking represents what many investors consider the essence of active management. Active managers rely on fundamental and quantitative research to help them find companies they believe will outperform over time. Furthermore, active managers have flexibility to time investment and are thus able to wait for an attractive price to buy a new position. In contrast, passive strategies do not consider valuations when buying a broad basket of securities. Additionally, active equity managers may cross market capitalisation, investment style or geographical boundaries when choosing stocks for a portfolio, opening up return opportunities that are unavailable to passive investors. Finally, active managers often hold a limited number of securities in a portfolio, frequently far fewer than passive strategies like index funds. Under the right circumstances, these factors may result in superior performance for investors.
Why active managers are well positioned for today's market
Certain economic and market environments tend to favour an active investment approach. In an environment where individual company fundamentals are more important than market-wide returns, active managers are more likely to earn their keep. Active fund management is better than index funds at guiding portfolios through rough times. In periods of economic turbulence, some companies stand to gain while others are apt to lose competitive positioning, creating both opportunities and danger areas for investors.
We think today's low-growth environment sets the stage for creating such market winners and losers. While 2008 was a year in which market risks dominated returns, driving correlations to increase dramatically, we believe these trends will reverse course as corporate fundamentals regain the attention of equity investors. This will likely produce differentiated returns, both in terms of sectors and individual stocks. Active stockpickers could therefore be positioned to hold the best performers while avoiding the worst performers - a benefit on both sides of the relative performance scale.
Given what we believe is an attractive environment for stockpicking, we feel active managers are well positioned to deliver results.
Matt Rubin is a director of investment strategy at Neuberger Berman
