Stock market volatility has been an opportunity to put active managers to the test, but few strategies have managed to beat the benchmark. Why are some institutional investors still holding on to actively managed strategies?
No investment strategy has experienced as many failed attempts to revive it from the dead in the past decade as active management. Since 2008’s financial crisis, the markets have been dominated by central bank intervention and as such has lost touch with fundamental valuations. With quantitative easing and ultraloose monetary policy persistently inflating asset prices, it has been hard to beat the index. But despite such challenging conditions, every so often a pundit, usually someone selling actively managed funds, predicts a comeback.
They have largely been proved wrong, but in the first quarter of last year a major bout of volatility hit the markets as the Covid-19 pandemic unfolded, giving active managers a long-awaited chance to prove their worth.
Stress test
March 2020 was a challenging time for investors with stock markets reporting their fastest transition to a bear market on record. Indeed, it only took 22 trading days for the S&P500 to lose a third of its value.
During such market shocks, conventional wisdom dictates that protection-seeking investors should turn to fund managers who operate independently of benchmark indices. But during the volatility caused by the global health scare, they did not.
Instead, investors paradoxically turned towards passive equities, says Dewi John, Refinitiv’s head of research in the UK and Ireland. “For March 2020, our fund flow figures show almost symmetrical outflows out of passive bond funds and into passive equities,” he adds.
For John, one possible explanation for this short-term movement could be liquidity, rather than performance of the assets. “If you are in a volatile market, you are going to have to move assets around quite quickly and that is a lot easier to realise with large cap liquid passives, which are famously used as trading instruments. “
The interesting thing is that looking over the data on a month on-month basis, passive hasn’t had a single negative month across all asset classes whereas active has had some very negative months,” he adds. “Each time money has been withdrawn from markets, particularly in March, it has come far more heavily from actively managed funds and when that money has been redeployed it has been in general redeployed more into passive vehicles than into active ones, and that is true across all asset classes. “If anything, the past year has strengthened the trend towards passive investing.”
Morningstar’s data shows why this may have happened. Its study of some 4,400 active and passive funds, concluded that in the first half of 2020 some 60% of actively managed bond funds failed to beat their passive counterparts, net of fees, while around half of large cap equity funds managed to do so.
There are exceptions to this trend. For emerging market equities, European equities and US real estate, actively managed funds generally delivered higher levels of outperformance, according to the data provider.
“The Coronavirus sell-off and subsequent rebound tested the narrative that active funds are generally better able to navigate market volatility than their index peers,” says Ben Johnson, Morningstar’s director of global ETF research. “Active funds’ performance through the first half of 2020 shows that there’s little merit to this notion.
“Across the 20 categories we examined, 51% of active funds survived and outperformed their average index peer during the first half of the year,” Johnson adds.
This ties into a longer-term trend. Over the past 10 years, less than a quarter of actively managed funds outperformed their passive rivals, according to the data provider. But the end of the year appeared to be a turning point for active fund managers. They reported their strongest inflows for more than five years, says Calastone, a data provider.
This, says Edward Glyn, Calastone’s head of global markets, was driven by buoyancy over the impact of vaccinations. “The growing optimism that characterised the end of 2020 is
reflected in the renewed appetite for active funds. Index funds are cemented into monthly savings plans and are now the default choice for most investors, but at moments of rising spirits and increased risk appetite, active funds benefit disproportionately as investors scour their fund ranges to find the one that meets their needs,” he adds.
In November alone, investors piled some £6.5bn into UK funds, out of which £4.6bn went into UK-domiciled equity funds. However, this picture is somewhat distorted by local government pension scheme pool Access launching a Global Alpha Equity fund, which accounts for £1.6bn of those inflows.
Precipice of change
Whether the short-term optimism we saw towards the end of the year can be sustained remains to be seen. But while active management might not make the dramatic comeback some asset managers might be hoping for, it is noticeable that the gradual decline of actively managed funds in institutional portfolios appears to have slowed down. In the past two years, the overall proportion of active mandates for pension schemes, insurers and charitable foundations has remained stable, according to Mercer’s asset allocation study.
Larger schemes tend to stick with active managers. Indeed, schemes with more than €2.5bn (£2.2bn) of assets typically have most of their alternative assets managed actively, holding on average around 12 such mandates. Smaller schemes, however, typically favour an active approach to equities, Mercer’s survey shows.
This raises the question of why schemes have not given up on active management, despite sustained challenges. One explanation might be growing awareness among investors that the extraordinary levels of monetary support shown by central banks and governments has to end at some point.
Mark Hedges, chief investment officer at the Nationwide Pension Fund, says many investors are aware that the global economy could be on the precipice of change. “We’ve had a very strange past 10 years where markets have essentially been underpinned by central banks and fundamentals were no longer underpinning valuations.
“If we look at factors such as the rise of tech, where a lot of it is being driven by retail flows, and as central banks start to retrench, I suspect that there will be some people that will take the view that we are going to see a mean reversion for value stocks, for example,” he adds.
But Hedges stresses that the decision on whether to keep faith in active management or not also depends on the scheme’s life cycle. For his own fund, where he manages some £5.8bn and is set to close for further accrual in March, he has had to make some drastic decisions by completely cutting out active management from all public market strategies.
“Eight years ago, our entire public markets portfolio was actively managed. In 2013 we switched our developed markets portfolio to passive funds,” he adds. “We kept our emerging market portfolio actively managed because we still saw some opportunities for out-performance. But over a four-year period, all those funds underperformed net of fees.
“It could be argued that we may have chosen the wrong managers, but we had three different managers following very different strategies, from growth to value. They were recommended by our advisers and we spent a lot of time doing due diligence. Even with that, they failed to outperform.
“As a pension fund that is closed to further accrual, we would find it very hard to convince trustees of actively managed strategies at this point. That is also a function of where we are at in our life cycle as a pension fund. It might be different for defined benefit (DB) schemes which are still open to further accrual,” Hedges says.
Having said that, the scheme has not fully given up on active management. Instead, it has opted for a relatively high allocation to private markets, across debt and equity. Around half of the scheme’s return-oriented portfolio, some 20% of its overall assets, is invested in actively managed private market strategies. This ties in with the trend of larger schemes opting for an active approach to their alternative strategies.
In contrast, David Stewart, chief investment officer of the British Airways Pension Scheme, is more optimistic on the potential of active managers to add value, even in public markets. He is adamant that despite heavily distorted markets, there are still opportunities for investors to add value but that most investors have been doing it wrong. “The standard institutional approach to active equity management [index plus 200 basis points] is an absolute killing ground,” he says.
“There is little evidence of sustainable success in that segment of the market – for long-term investors, these strategies have a very low probability of success.”
Stewart argues that investors should fundamentally change their perspective. “There is a wide body of evidence that a very high-conviction bottom-up equity approach is probably the most viable form of active equity management.”
However, there is one key challenge for investors who wish to do so, Stewart acknowledges. The research also indicates they would have to embrace the near certainty of sustained periods of under-performance, a perspective that might be hard to defend in investment committee meetings. “Faced with more than three years of solid under performance, most trustees are likely to say that they can’t live with that and the scheme will divest from managers at exactly the point where things are being turned around. The best long-term managers can only outperform if investors give them the opportunity to outperform,” he adds. “And that means combining four to six high conviction mandates rather than putting all the eggs in one basket.”
But he is also adamant that this approach is not about picking a star manager or chasing short-term performance. “Ultimately, this is about fully understanding the investment process, it has as much to do with culture as capability.” Doing so could help pension funds to be more comfortable with inevitable periods of under-performance, he believes.
For those schemes, which do not have an in-house investment team, consultancies could provide the necessary guidance, Stewart says. But it might require a fundamental change in perspective, he admits.
Going forward, a crucial question remains whether this change in perspective will be embraced not just by larger DB schemes, but also by rapidly growing defined contribution (DC) schemes. The challenges of the charge cap and their relatively modest asset volumes have largely confined
them to passive strategies, while the poor performance of active asset managers has proven little incentive for change.
But with DC scheme assets growing rapidly, there is evidence that they are increasingly considering active approaches. Autoenrollment specialist NEST is at the forefront of this trend. Its £15.5bn under management is growing by around £400m a month, volumes that allow the scheme to negotiate harder on manager fees. The result is that it employs a range of active managers who cover asset classes such as emerging market debt, commodities, real estate and investment-grade bonds.
Nico Aspinall, chief investment officer at £13bn workplace pension provider The People’s Pension, says that cost awareness should not be conflated with index hugging. He sees the recipe for success in a systematic approach and having a higher active share. “It is still difficult to be an active manager in this market. I would not frame us as being a passive investor. Market cap is the lowest cost and simplest route to access a market but is not always the best.
“We have some reasonably substantial deviations from market capitalisation and most people wouldn’t see that as pure passive,” Aspinall says.
Adding value
Whether schemes focus on alternative, bottom-up equities or more systematic approaches, it appears that despite the performance challenges, investors are not ready to give up on active management.
One reason could be that the growth outlook and macro-economic challenges for the next decade might look different from the previous one, Stewart says. He believes that we are about to enter a period of low growth. “Equity indices will be very dull over the next 10 years. But precisely because the growth outlook is weak, investors will have to be open to look beyond indices. There are always going to be opportunities.
Equities are a warrant on human ambition, a call option on human ingenuity and those things underpin growth, equities are the indispensable growth asset,” he believes. “If you want to capture growth asset returns you have to be highly selective, but it’s got to be the right kind of active management.”
