The changing market environment means that passive funds are starting to look less attractive while conditions could be emerging where active managers can shine, Janus Henderson’s Nick Watson argues. 
Recent years have seen investors flock into passive strategies, drawn in by their low fees, transparency and ability to track the liquidity-driven bull market. Index-tracking products have seen their assets under management swell over this time; the latest figures show that 13.8 per cent of the money in the Investment Association universe is invested in index trackers, accounting for £163bn of investor cash.
Active managers, on the other hand, have tended to see money flow out of their products as investors take issue with their relatively high ongoing charges and some lacklustre returns over the past few years. A particularly weak year for active funds was 2016, when the Brexit results and Donald Trump’s US presidential win took many portfolio managers by surprise.
Performance of average UK fund vs index in 2016
Source: FE Analytics
However, Watson – a portfolio manager in Janus Henderson’s multi-asset team – said that investors should be wary of taking the view that passive or active is always the ‘right’ approach to use. Instead, he argued that knowing when is the most opportune time to use each approach is a vital skill.
“Central to our approach is the belief that active managers do add value – just not in every market environment,” he said. “Just as an asset allocator aims to add value by navigating between asset classes, regions, and investment styles throughout the course of a market cycle, blending active managers with passive instruments to different ratios at different times also has the ability to enhance client returns.”
The manager said historical data suggests active management can add value in lower return environments but passive strategies tend to perform better in “raging bull markets”, when intra-market correlations rise and fundamentals recede.
“Given our view of current market conditions – elevated valuations, uncomfortable markets levels, the maturing of the economic cycle and the withdrawal of the quantitative easing (QE) punch bowl – we see a sustained lower return, higher volatility environment ahead,” Watson continued.
“As such, we are tilting our instrument selection towards active managers across equities and fixed income.”
However, the multi-asset manager added that active investing appears to be more suited to some areas and asset classes than others. He highlighted the UK and European equity sectors as two areas where the average active manager has offered investors improved outcomes in terms of lower risk and higher returns than the index over the medium term.
This is illustrated in the below scatter chart, which shows the total return and annualised volatility of the IA UK All Companies and IA Europe ex UK sectors against the FTSE All Share and MSCI Europe ex UK indices over the past five years. The average fund in both sectors has outperformed the market with lower volatility over this period.
Risk/return of sectors vs indices over 5yrs
Source: FE Analytics
“From a fund selector or asset allocator perspective, there is a broad universe of talented active managers from which to select and add a level of alpha. There are many compelling examples of long-term fund managers, who have added alpha over the long run despite dramatically different investment styles and philosophies,” Watson said.
“The skill when selecting these is identifying the alpha generators who genuinely add value and then blending them to suit one’s overall top down view.”
He added that in emerging markets and Asia active strategies can achieve better risk-adjusted returns than passive strategies over the long run as managers tend to lag strong markets but smooth out volatility during rougher periods.
Even US equities – an area where active managers have tended to struggle over the long term – can have periods when an active approach is warranted, in Watson’s view.
The US large-cap market is the most researched in the world and, as such, presents a lack of inefficiencies for active managers to exploit. In addition, years of intense monetary stimulus appear to have created a “drought of alpha”, whereby markets have been all-time highs and investor attention focused away from fundamentals.
In this environment, around three-quarters of active US large-cap funds have underperformed the S&P 500 – not only since the start of quantitative easing by the Federal Reserve but over the past three years as markets reached record highs.
“At this point, you might assume that we would choose to go fully passive for US equities. The reasoning being that the opportunity cost of active management appears too great in this region (as markets are so efficient) and the scope for bottom-up analysis to add value is negative,” Watson said.
“Not so. In reality, we are moving in the opposite direction by fading out of passive equity exposure in favour of active managers. This is because timing is also a crucial consideration for active and passive investment. There is a time and a place for active managers – and we think that time is now.”
Active US managers have lagged raging bull markets
Source: Janus Henderson, data from February 1991 to February 2018
The multi-asset manager noted that active US funds have underperformed in strong bull markets. In fact, when the S&P 500 has risen by an annualised 25 per cent over a three-year period, active US managers underperformed on average by around 4 per a year.
However, when the S&P has made less than 10 per cent annualised on a three-year basis, US active managers have used the more modest return environment to generate alpha net of fees over the market.
“All investors have benefited from the fantastic investment environment of the past eight years, with low but improving growth expectations, muted inflation, cautious positioning, and QE depressing volatility and supercharging investment returns across all asset classes,” Watson said.
But he added that “the tone of this market rally is changing” with interest rates starting to rise, inflation picking up and quantitative easy being withdrawn. These macro factors come as valuations look elevated and corporate profitability reaches historically high levels in the years – making an outlook of lower returns going forward seems more probable.
“We believe that this environment should suit active managers in all asset classes, as fundamentals return to the fore and beta is less of a driver of returns,” he concluded. “It is this environment that presents a more fertile hunting ground for active managers to add alpha – alpha that is going to become increasingly valuable.”