Much has been made of the underperformance of active US equity managers in recent times and some of these warnings do warrant investor attention.
However, it is equally important to understand the underlying drivers of performance for an equity market. The most popularly tracked US equity market is the S&P 500 with a market cap of over $21trn.
By far the largest sector, accounting for nearly a quarter of the index, is the technology sector. An area that has enjoyed huge growth in the last 10 years but not one without its risks as veterans of the infamous “dotcom bubble” of 2000 will testify to.
The technology sector is broadly recognised as a growth industry, where companies typically reinvest profits to grow, rather than pay them out as dividends to shareholders.
Herein lies the issue when making simple inferences of performance relative to a benchmark. Many investors are focused on generating an income from their portfolio to sustain their retirement or lifestyle.
As a result of their requirements, portfolios are positioned towards income generating (or dividend paying) stocks. Performance data reveals that returns for active US equity managers with a focus on generating income have been materially lower than the benchmark (S&P 500), principally because their investment style bias has been out of favour.
Take the example of Facebook or Google (now called Alphabet), two companies that do not pay a dividend and thereby would not qualify for inclusion in an income portfolio. Yet despite not paying a dividend over the past five years (and accounting for over 4 per cent of the benchmark) the capital growth of the two stocks amounts to a lofty 396 per cent and 233 per cent, respectively.
Given the benchmark has achieved slightly over 100 per cent over the same period one can see how an income-orientated investor, specifically, would have underperformed an S&P 500 benchmark.
For the UK equity market, a strong understanding of the underlying sector biases (and, again, thereby performance drivers) within an index is just as important.
In the middle of 2014, prior to the oil price crash, energy companies accounted for almost 18 per cent of the FTSE 100 – dominated by the likes of Shell and BP. Unsurprisingly, as commodity prices fell that summer, so too did the benchmark (FTSE 100). Both continued to do so for the next 18 months.
During this period active managers in the UK were able to significantly outperform the benchmark, avoiding commodity-related companies and being broadly quite nimble. As the oil price bottomed out at the start of 2016, Thomas Miller Investment rotated away from active managers and into the passive tracker.
Knowing our active managers were structurally underweight the Energy sector, portfolios were able to benefit from a cyclical upswing in the global economy as the oil price rallied back.
Then again at the start of 2017, for reasons not limited to commodity prices, portfolios moved back towards active UK equity managers and away from the passive tracker.
A considerable level of outperformance of the FTSE 100 benchmark has been achieved through our investment process. In seeking to understand where our active managers hold genuine skill and where the benchmark contains structural biases we have been able to add alpha. Indeed the UK equity allocation has been an important driver of returns for client portfolios.
We believe that divergences in sector returns is only the start of the journey back to a more normalised economic environment. With a more transparent read on the underlying economy, one possibly less manipulated by central bank intervention, active managers now have the platform to outperform their respective benchmarks.
Furthermore, we make the argument that to invest in passive-only portfolios ignores the inherent risks that exist within every equity market. Whilst the passive approach may have worked well in the US equity market, the same cannot be said for the UK equity market. For the UK investor with a dominant home bias to their equity allocation the difference in return profile is material.
Whilst opportunities to outperform their equity market benchmarks will improve for active managers, it remains fundamental to performance in a multi-asset portfolio that investors understand the underlying risks to a passive tracker are just as important.
Jordan Sriharan is head of fund research at Thomas Miller Investment. All views are his own and should not be taken as investment advice.