The changing investment backdrop caused by the end of quantitative easing is going to be more supportive for active managers focused on US equities going forward, according to Columbia Threadneedle’s Nadia Grant.
Grant, who is head of US equities and also manages the £2.49bn Threadneedle American fund, said the normalisation of monetary policy by the major central banks and its side-effects – such as volatility – will lead to outperformance of active managers.
“Since 2011 volatility has been supressed,” she explained. “What you can see between 2003 and 2007, as volatility was riding, is that that was a period where active managers did indeed outperform.”
“For active management it is extremely important to have declining stock correlation and increasing volatility since, as a good portfolio manager you want that spread between the good companies and the non-fundamentally sound ones.”
US stock correlation over 20yrs
Source: Columbia Threadneedle
In the wake of the global financial crisis, major central banks adopted unprecedented tactics aimed at stimulating growth through ultra-loose monetary policy.
Between 2008 and 2015, the US Federal Reserve bought bonds worth more than $3.7trn and the UK created £375bn in new money. The European Central Bank has also been boosting the eurozone money supply by buying €30bn of assets each month.
Quantitative easing period helped prevent a financial system meltdown, but also led to a period of very low volatility and synchronised global growth, which pushed most assets up and benefited passive instruments.
But as central banks call a halt to quantitative easing and volatility makes a comeback, Grant said dispersion among stocks will start increasing, making it harder for passive strategies to outperform.
She said: “A good indication was 2017 that was a great year in terms of stock correlation declining, that has been associated with large inflows into active management and large outperformance of active managers.
“Manager outperformance tends to be quite cyclical and active management really benefits from that rising dispersion among stocks and tends to outperform as dispersion increases in the market,” said the Threadneedle American fund manager.
“We are constructive. We think the backdrop of quantitative easing was a tough one for active management but quantitative tightening should be far more supportive for alpha generation.”
While the US market is said to be one of the most efficient – and as such more difficult to generate alpha – Grant said the behavioural economics suggests that might not be the case.
“We don’t think is fair to say the US market is efficient and alpha cannot be achieved. In our case, we have distanced ourselves from the peer group,” Grant noted.
“The US has been the most disrupted by the rise of passive funds, which now account for a third of the trading volume.
“However, we think that behind the theory of effective market lies the assumption that market participants are rational. But we don’t think that is the case.”
Performance of index over 10yrs
Source: FE Analytics
According to Grant, acknowledging investors are humans and therefore not purely rational but instead have emotions, fears, needs and behavioural biases is a key ingredient for generating alpha.
“Investors show behavioural biases and errors that affect the decision making,” the manager noted. “As such, what we try to do with our strategy is to try to recognise those biases on our end, limit those biases and exploit those of the market.”
Some of the behavioural biases inherent to investors result in mispricing in the market, something the Threadneedle manager tries to capitalise on.
“One very common behavioural bias is overconfidence: as humans we are poor judges of our ability and we try to overestimate our own capabilities, which as fund managers leads to being unduly optimistic about stocks we have bought,” Grant explained.
“This can lead to a quality mispricing, there is evidence that shows that discipline teams – those disciplined with the capital allocation – tend to outperform.”
Overconfidence can also lead to value mispricing as Grant said portfolio managers may disregard changes in the fundamentals of the company just because they have decided to underweight it in the first place.
Loss aversion, or the tendency to prefer avoiding losses, is another common behavioural bias influencing the decision-making process.
“It affects our choice making as we try to minimise the loss and not maximise the gain because we are too focused on the risks. This, although natural, is not positive when it comes to investing,” she added.
Another behavioural bias is anchoring: “Investors anchor to certain targets such as breakeven point despite the fact that there are purely arbitrary, they hold losing positions and sell winners too early.”
As Grant pointed out, these behavioural biases lead to mispricing such as value or momentum arising in the market place, a reason why she decides to focus on quality stocks.
“In our strategy we focus on quality stocks as those are the ones that benefit from improvement in the business fundamentals, are cheaper than the market and tend to outperform.”
Top holdings in the £2.49bn fund include some of the popular and best-performing FAANG stocks, such as a 4.7 per cent weighting in Amazon, 4.7 per cent in Google’s Alphabet and a 4.0 per cent in Apple.
Performance of fund vs sector over 3yrs
Source: FE Analytics
Over three years, Threadneedle American has delivered a 64.71 per cent total return compared with a 55.48 per cent gain for the average fund in the IA North America sector. The fund has an ongoing charges figure (OCF) of 0.83 per cent.