the recent challenges of active equity investing – and why this … · we show how a number of...

In focus

Since Schroders published our paper on the case for active asset management in 2017, the performance of active equity managers has continued to face headwinds. In previous bright spots, such as the UK and emerging markets (EM), fewer than half of active managers have beaten the index. In the US, beating the index has been as difficult as ever (Figure 1).

At the same time, flows from active to passive have continued unabated. In August 2019, US passive equity mutual funds surpassed their active counterparts in assets under management. The shift to passive is less advanced in Europe,

where active equity funds remain the dominant vehicle with 71% market share1.

In this paper we look at what could explain this performance, including drivers that have previously explained the relative performance of active management, such as factor exposure, market breadth, cross correlations and dispersion of stock returns. We show how a number of headwinds have coincided in recent years, damaging the performance of active managers.

1 Source: Morningstar. Data as at 30 August 2019.

Since the global financial crisis active equity managers have faced significant challenges, as we wrote in 2017. This trend has persisted in the past two years, spilling over into previous bright spots such as the UK and emerging markets. Yet, perhaps surprisingly, this kind of underperformance is not unprecedented; active management tends to be cyclical. The question for investors is whether anything is different this time and if active returns will recover from this low point.

Marketing material for professional investors and advisers only

Kristjan Mee, CFAStrategist

Gavin RalstonHead of Official Institutions and Thought Leadership

Figure 1: Percentage of active large cap blend funds outperforming (rolling five-year returns net of fees)

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Past performance is not a guide to future performance and may not be repeated.Source: Schroders, Morningstar. Includes active open-ended equity funds; retail share class with longest history preferred. Performance measured against the primary prospectus benchmark. Data as at 31 October 2019.

The recent challenges of active equity investing – and why this might changeJanuary 2020

This level of underperformance is not unprecedented. Around the turn of the century, active managers went through a similar stretch of subpar returns. Active performance tends to be cyclical, meaning that periods of poor returns are usually followed by a rebound in the number of managers beating their benchmarks. Furthermore, a number of factors in the market environment could change and lead to a better future environment for active management.

Note that this analysis is focused on large cap managers. Small cap managers, not covered in this paper, have been able to perform well due to the unique characteristics of the small cap market, as we have written previously2.

Finally, we note that ESG is becoming an increasingly important component of the investment philosophy of many asset owners. Whilst we are not assessing this important area in this paper, we believe that active managers possess distinct advantages in integrating ESG and other data. For papers on ESG please see: SustainEx: Quantifying the hidden cost of companies’ social impacts3; Five practical issues of incorporating ESG into multi-asset portfolios4.

How value factor exposure has driven active performanceBy far the most important driver of the performance of active equity portfolios over the last decade has been the investment style of the manager, most notably the degree to which their process incorporates valuation. Despite the well-documented long-run tendency of cheaper stocks to outperform, value has underperformed growth since the global financial crisis. Measured by the return of the Fama-French US value factor, the past few years have been unusual in that, with a brief exception in the late 1990s tech bubble, the rolling 10-year returns to value have never been negative, let alone for such an extended period (Figure 2).

This is not just a US phenomenon and value has performed poorly across regions. There are a multitude of reasons for this underperformance, most notably a prolonged period of slow economic growth, quantitative easing and historically low interest

2 Matthew Dobbs, Kristjan Mee, “The case for global small company investing in an era of disruption”, Schroders, June 2019.

3 Andrew Howard, “SustainEx: Quantifying the hidden cost of companies’ social impacts”, Schroders, April 2019

4 Lesley-Ann Morgan, Jessica Ground, Ben Popatlal, “Five practical issues of incorporating ESG into multi-asset portfolios”, Schroders, May 2019.

rates. In this environment, the market has rewarded companies that have been able to deliver strong secular earnings growth or at least the expectation of such growth in the future.

Active managers have not always been overweight value. Figure 3 shows the average rolling two year exposure of active managers’ excess returns to value, as measured by their regression based beta, based on the MSCI Value indices. Negative betas in the wake of the financial crisis show that managers underweighted value and overweighted growth stocks. Specifically, US managers overweighted technology stocks and eurozone managers underweighted financials (Figure A, Appendix). US technology stocks have been the biggest winners and eurozone financials the biggest losers in this cycle.

Figure 2: Long-term performance of value factor

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Past performance is not a guide to future performance and may not be repeated.Source: Schroders, Kenneth French’s Data Library and Schroders. Data as at 31 August 2019. Based on monthly returns of the US Fama/French HML (High Minus Low) Factor. HML is the return on the “high” portfolio minus the return on the “low” portfolio, where book-to-market is used as the value metric.

Rolling 10-year annualised return of the Fama-French US Value Factor

Figure 3: Large cap blend funds average rolling three-year beta to value

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Past performance is not a guide to future performance and may not be repeated.Source: Schroders, Morningstar, MSCI, Refinitiv Datastream. Includes active open-ended equity funds; retail share class with longest history preferred. Performance measured against the primary prospectus benchmark. Beta is the output of regression of manager excess returns against factor excess returns. Data as at 31 October 2019.

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In early 2016, active managers started to reduce their exposure to growth stocks, most likely because growth stocks were perceived to be expensive. Improving economic growth and the election of Donald Trump in late 2016 led to a short revival of value but underperformance soon resumed. In hindsight, active managers were too early to discount the potential of growth stocks, and too optimistic on the prospects of value stocks.

The latest data show that US managers have maintained their overweight to value and are also showing a significant underweight to technology. This positioning has cost performance. Eurozone managers are again slightly underweight value after increasing exposure to neutral between 2016 and 2018, leading to better relative performance than US managers.

What could the value-growth dynamic mean for active performance in future? We have seen a similar story play out before. In the late 1990s and early 2000s, the vast majority of active managers underperformed because of their reluctance to buy speculative technology stocks. The caution paid off handsomely, as value stocks outperformed for several years following the bursting of the dot-com bubble (see Figure 1).

While growth stocks are not as extremely overvalued as they were two decades ago, value stocks are still cheap compared to their recent history, as measured by our composite valuation indicator (Figure 4).

The large valuation gap means that small changes in expectations could trigger a reversal in relative value-growth performance. There is no doubt that the earnings of growth stocks can continue to outpace the earnings of value stocks. However, as our research shows, expectations have become very one-sided.

We can extract implicit earnings growth assumptions from valuation multiples to determine the growth rates required to justify current valuations. In Figure 5 we plot this measure for three value baskets from cheap to expensive. The bar is clearly set low for the cheapest stocks as the market is implicitly predicting a contraction in earnings of more than 3% per year for the next few years. This is well below what has been achieved historically and what analysts are currently expecting (+5.8%). In contrast, the most expensive stocks will have to grow at an annualised pace of 27% to justify their current valuations, which is more than double what analysts anticipate and much more than these companies have achieved in the past.

Besides a shift in the implied growth expectations, a related trigger for value-growth performance may also be found in political developments. In our recent paper5, we show how rising industry concentration in the US has given a rise to “superstar” firms that dominate their respective industries. Firms such as Microsoft, Amazon, Google, Apple and Facebook have been able to consolidate their market power and generate abnormal profits and equity returns. The rise of superstar firms has been driven by a wave of M&A resulting from lax enforcement of antitrust policies.

Although investors have benefited greatly from this winner-takes-all market in the technology sector, there is a growing concern that it is harming consumers and worsening income inequality. Consequently, there are increasingly loud calls for government to rein in large corporations. Recent reports indicate that federal agencies are investigating some of these technology companies and the House Judiciary Committee is launching an antitrust probe of Big Tech. A tougher regulatory environment poses significant downside risks to superstar firms’ ability to sustain abnormal profit growth. While the enforcement process could take years, the impact on future growth may increasingly be reflected in valuations today.

Regardless of the driver, should the value-growth dynamic shift, active managers would be better placed to capture the potential of undervalued stocks.

What about other equity factors? Continuing with equity factors other than value and growth, momentum has been the best performing factor in all regions over the last decade. Research shows that the existence of momentum in stock returns is a blatant violations of the efficient markets hypothesis. Active managers seem to have, more often than not, a positive beta to momentum (Figure B, Appendix). However, as momentum has become exceedingly negatively correlated with value, especially in the US (Figure 6, overleaf), managers’ preference for value today has resulted in a more moderate overweight, or even underweight, to momentum. Active managers seem to be betting on significant reversal in momentum, which as we know happens from time to time.

5 Sean Markowicz, “The rise of US superstar firms and the implications for investors”, Schroders, October 2019.

Figure 4: Value discount has increased in the last two years

Source: Schroders, IBES, data from January 1994 to November 2019. Value basket is formed from a liquidity weighted average of the cheapest tercile of global stocks based on a MSCI ACWI universe (composite of forward earnings, book and sales). Growth basket is formed from a liquidity weighted average of the fastest growing tercile stocks based on an MSCI ACWI universe (2 year forward growth).

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Figure 5: Implied growth and forecast growth by value cohort

Source: Schroders, as at 30 September 2019. We form 3 terciles from our global value rank – we restrict this to mid, large and mega caps and exclude Financials and loss-makers. We compute the market cap weighted implied and forecast growth for these three groups. We trim the growth metrics at 5th and 95th percentile to reduce the impact of outliers. We extract the implied growth from the Residual Income Valuation Model – this is the short-term growth rate which if applied to consensus earnings forecasts results in the current valuation. The key assumptions in this model are the cost of capital which is the measure we use to discount future earnings back to present value and the time periods over which we expect a company’s growth rate and profitability will deviate from the market. 3 Year Forecast Annualised Growth is the growth rate over the next 3 years based on Starmine Smart Estimates.

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Interestingly, the high negative correlation between value and momentum bears a resemblance to the late 1990s and the early 2000s. Back then, the consequent reversal in both value and momentum was extremely sharp, highlighting the danger of a similar kind of reversal if the expectations built into the stretched valuations of large growth stocks should falter.

In addition, the proliferation of various smart-beta strategies over the last decade further complicates the situation. The different factor ETFs tend to hold an overlapping set of stocks, partially the result of market capitalisation based construction within each factor. For example, Apple has a weight of 4.2% in Russell 1000. On the other hand, Apple’s weight in popular growth, quality, minimum volatility and momentum strategy ETFs ranges between 4.6% and 8.2%6. Consequently, the implications of a sharp sell-off in these strategies are significant as many have not been tested in an environment of market stress.

Finally, active managers tend to overweight smaller companies relative to large cap benchmark stocks, highlighted by the consistently positive betas to size tilt indices (Figure C, Appendix). Intuitively, this makes sense. Mispriced stocks are more likely to be found among the lower market capitalisation stocks. Unfortunately, in the environment where big companies have continued to get bigger, this strategy of seeking smaller undervalued stocks has not paid off. However, history also suggests that periods of increasing concentration in equity markets do not persist, whether it be due to valuation concerns or increasing competitive forces.

What have been the other drivers of active performance? At an individual stock level, the ability of active managers to add value is determined by cross-stock correlations and the dispersion of stock returns. The former measures the extent to which stock prices move together, the latter the difference in the returns of the best and worst performing stocks. In a 2017 paper, we showed that active managers do best when cross-correlations are low and dispersion is high7.

Unfortunately for active managers, the post-global financial crisis period has been characterised by high correlations and low dispersion. Markets have been driven more by broad macroeconomic themes, such as the expectations of central bank easing, and less by future prospects of individual companies (Figure 7). Cross-stock correlations dropped in 2016 but have rebounded since. At the same time, the dispersion of returns has remained very low, limiting opportunities for active managers to deliver excess returns.

6 Source: Bloomberg. Data as at 12th December 2019. Apple’s weight in smart-beta ETFs: iShares Russell 1000 Growth ETF (8.2%), Invesco Russell 1000 Quality Factor ETF (7.8%), Oppenheimer Russell 1000 Low Volatility Factor ETF (5.9%), Fidelity Momentum Factor ETF (4.6%).

7 Clement Yong, “The acid test of active management”, Schroders, November 2017.

Figure 6: US rolling 5-year correlation between value and momentum

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Past performance is not a guide to future performance and may not be repeatedSource: Schroders, MSCI, Refinitiv Datastream. MSCI USA value and momentum indices. Data as at 31 October 2019.

This dearth of opportunities is also evident when looking at the potential return from correctly forecasting earnings. Figure 8, overleaf, shows the alpha that an investor would generate if they were lucky enough to own a “crystal ball” which revealed companies’ future earnings reports. Every July, companies are sorted based on the difference between the actual one year ahead earnings and the consensus forecast at the time. The strategy buys the companies that deliver better than expected results, which is effectively what a lot of managers seek to do, and tracks the subsequent alpha generated.

It is clear that the return from correctly forecasting earnings has more or less halved in the last 10 years. When stock prices are less responsive to company-specific news, even the smartest analyst cannot fully capitalise on their ability to predict earnings.

In part this reflects the fact that many stocks have been neglected. Indeed, the returns are being produced by increasingly fewer stocks, highlighted by the narrow leadership of the market. This development is closely related to the rise of “superstar” firms that we mentioned earlier. As industries have become more concentrated, so have stock market returns. For example, over the past five years, the top 20 performing stocks in the Russell 3000 Index, representing just 0.7% of the total number of stocks, accounted for as much as 39% of the index’s total return. And just five companies out of 3000 – Microsoft, Apple, Amazon, JP Morgan and Facebook – accounted for 22% of the index’s total return8.

8 Source: Bloomberg and Schroders. Five years to 13 December 2019.

Figure 7: S&P500 pair-wise correlations and dispersion in stock returns

Past performance is not a guide to future performance and may not be repeatedCopyright © 2019 Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Schroders’ use of such information. The information is provided “as is” and none of BAC or any of its affiliates warrants the accuracy or completeness of the information. Source: BofA Merrill Lynch. Based on 90-day periods. Data from 30 June 1986 to 2 December 2019.

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What is the outlook for the drivers of active performance? We believe that the headwinds described above are cyclical. While it is not easy to forecast cross correlations, dispersion or market breadth precisely, we believe that the conditions are set for a reversal, at least with respect to the latter two. As everything in markets moves in cycles, and the current cycle displays many extremes, market leadership tends to increase with volatility, as does dispersion.

Most investors would describe the current state of the economy and markets as “late cycle”. This environment is usually associated with high confidence, leading the markets to overlook potential issues ahead. However, should confidence wane, the individual prospects of companies are likely to come to the fore and stock prices to become more differentiated.

Given that the dispersion of returns increases with uncertainty, it is not surprising that active managers tend to do better in challenging times. For example, in 2001 and 2003, and again in 2008 and 2009, the percentage of funds outperforming noticeably increased, both in the US and the eurozone (Figure 9).

Furthermore, even if the payoff from correctly forecasting earnings has fallen, some alpha still remains, as seen in Figure 8. That is not to say that realising that alpha is easy.

Figure 8: The payoff from correctly forecasting earnings has fallen

Past performance is not a guide to future performance and may not be repeatedSource: Schroders, Refinitiv Datastream. Data as at 31 December 2016. Based on Datastream Global Equity Index. Every July we calculate the difference between the actual reported earnings for the following year and the one year forward consensus earnings forecast made at that date. We exclude any companies with negative earnings and companies where the percentage difference is very high or very low (top or bottom 2% of growth). We rank companies from high to low on the percentage difference between the earnings they would go on to report and the forecast earnings at that time. We make an index of the companies in the top quartile of that ranking in each year and compare the performance of the index to the overall universe to estimate alpha.

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Figure 9: Active managers’ performance usually improves in down markets

Past performance is not a guide to future performance and may not be repeatedSource: Schroders, Morningstar. Includes active open-ended equity funds; retail share class with longest history preferred. Performance measured against the primary prospectus benchmark. Data as at 31 October 2019.

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ConclusionMany active managers have struggled in the last decade to add value. As the markets have been driven by the strength of a small number of stocks, the payoff from correctly predicting earnings, the key part of many fundamental strategies, has fallen. The relentless growth of large “superstar” firms in the technology sector and their dominance of market returns, has been a challenge for active managers who use valuations as a key input in the investment process.

We have sought to show in this paper that many of the factors that have led to underperformance could reverse. In particular, if we see better performance of value stocks, increased differentiation in the prospects of individual companies, and greater volatility, active management should reassert its importance in investment portfolios.

As access to financial data is widespread and cheaper than ever, new information is disseminated and priced in much faster. After all, algorithms have finished analysing an earnings report before humans have had a chance to even open it. It is arguable that fundamental research-driven investors will be disadvantaged compared to quantitative investors whose edge is in fast data processing capabilities.

But even with the advent of new technologies, humans are still better at understanding and identifying causal relationships. Any quantitative model will first have to find the right questions to ask. Rather than pitting fundamental and quantitative approaches against each other, humans and technology can work together to deliver the best investment outcome. This means that active managers need to invest in acquiring non-standard data and specialists who know how to interpret that data.

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Appendix

Past performance is not a guide to future performance and may not be repeatedSource: Schroders, Morningstar, MSCI, Refinitiv Datastream. Includes active open-ended equity funds; retail share class with longest history preferred. Performance measured against the primary prospectus benchmark. Beta is the output of regression of manager excess returns against factor excess returns. Data as at 31 October 2019.

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Figure A: US large cap blend funds average rolling 3-year beta to technology and Eurozone large cap blend funds average rolling three-year beta to financialsUS technology Eurozone financials


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Figure B: Large cap blend funds rolling three-year beta to momentum

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Important InformationThe views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds.

This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument or security or to adopt any investment strategy. The information provided is not intended to constitute investment advice, an investment recommendation or investment research and does not take into account specific circumstances of any recipient. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice.

Information herein is believed to be reliable but Schroders does not represent or warrant its completeness or accuracy. No responsibility or liability is accepted by Schroders, its officers, employees or agents for errors of fact or opinion or for any loss arising from use of all or any part of the information in this document. No reliance should be placed on the views and information in the document when taking individual investment and/or strategic decisions. Schroders has no obligation to notify any recipient should any information contained herein changes or subsequently becomes inaccurate. Unless otherwise authorised by Schroders, any reproduction of all or part of the information in this document is prohibited.

Any data contained in this document has been obtained from sources we consider to be reliable. Schroders has not independently verified or validated such data and it should be independently verified before further publication or use. Schroders does not represent or warrant the accuracy or completeness of any such data.

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Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall. This document may contain “forward-looking” information, such as forecasts or projections. Please note that any such information is not a guarantee of any future performance and there is no assurance that any forecast or projection will be realised.

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