Last Wednesday, stocks fell and the dollar rose after Federal Reserve Chairperson Janet Yellen essentially confirmed that the central bank would be raising short-term interest rates at the next Federal Open Market Committee meeting in mid-December. On Thursday, stocks, bonds and the dollar plunged after European Central Bank President Mario Draghi appeared to suggest that the ECB might not be as accommodative as expected. Friday, stocks soared while bonds and the dollar rebounded after a better-than-expected U.S. jobs report and a speech in which Draghi indicated that he had been misunderstood a day earlier.
To some, last week’s violent moves in equity, fixed-income, currency and commodity markets mean that now is probably not the time to be weighing the issue of active versus passive investment management. But such a perspective is short-sighted. For various reasons, an imminent rise in U.S. interest rates and the prospect of a continuing divergence between U.S. and non-U.S.monetary policies suggest that conditions are finally ripe to see market-beating performance from hedge funds and other active managers. Until now, it has been fine to passively go along with central-bank induced asset inflation, but the looming course change is likely to create the kinds of trading opportunities that have been rare during an era of “risk on” and “risk off.”
Change is in the air
As I noted in “CTA Investing: The Trend to Follow,” correlations within and across asset classes have been rising for some time. This largely reflects the broadly singular focus on central bank policymaking. But now that the Fed is ostensibly seeking a return to “normalcy,” or at least, the kind of environment that prevailed prior to ZIRP, QE and the global financial crisis, odds are that we will see a rediscovery of other factors that can influence securities prices, including macro trends such as growth and inflation, and fundamentals such as earnings, sales and creditworthiness, which played a significant role before central banks took charge. These and other crosscurrents will likely lead to greater variations in returns, which means more opportunities for capable investment managers to generate alpha.
Based on research by Michael Mauboussin, managing director and head of Global Financial Strategies at Credit Suisse, there are two predictors of success in active management: skill and opportunity. Arguably, one reason why so many talented managers in recent years seem to have lost their way or dropped out of the game entirely stems from the fact that the performance of securities in various markets did not diverge all that much from one another. Among other things, Robert Huebscher writes in “Why Active Management Failed in 2014,” Maboussin found that “higher ‘diversity’ in the market correlated with positive active management results. The fewer the stocks that comprised the top 50% of the market capitalization of equities, the better active managers did.”
Huebscher added that “according to Mauboussin, ‘dispersion’ [which is a measure of magnitude, as opposed to ‘correlation,’ which gauges timing] is the best indicator of opportunity for active managers. The more tightly clustered the returns are for the stocks in an index, the lower the dispersion and the harder it is for active managers to do well.”
Higher rates, greater volatility
The fact that the Fed is set to change course after seven years of single-minded policy-making isn’t the only reason to believe that the outlook for active management is improving. Historically, a rising interest-rate cycle tends to reverberate across fixed-income, equity and other asset classes. As strategist Robert Doll wrote last June in a column for Barron’s, “rising interest rates tend to be associated with periods of market volatility.” In his view, “more volatility means more opportunity for active managers to identify mispriced securities.”
Not surprisingly, hedge funds and other managers who can buy undervalued securities and sell (or sell short) overvalued counterparts could be the biggest beneficiaries of such a change. According to Brad Neuman, an investment analyst at Alger Funds, “hedged equity has historically beaten the overall market in a rising-rate environment. Over the past three tightening cycles, hedged equity, as represented by the HFRI Equity Hedge Index, outperformed the S&P 500 index by an average of 630 basis points annually.”
Talent still matters
Of course, even if there are more opportunities available, that doesn’t mean managers will capitalize on them. To reiterate what Mauboussin noted above, investing acumen is a necessary ingredient. Interestingly, a firm that has become synonymous with low-cost index investing but which actually has substantial actively-managed assets under management recently published a paper, “Keys to Improving the Odds of Active Management Success,” where it argued as much. While Vanguard makes it clear that low fees are a critical component of above-average returns, it maintains that “no quantitative factor alone can help ensure outperformance. A rigorous and thoughtful qualitative manager-selection process to identify top talent is also essential.” To do this, they rely on the 4Ps, a topic that was discussed previously at Sophisticated Investor.
Even if one can identify the best managers, that doesn’t necessarily mean they will do well in the short run. In fact, Vanguard maintains that patience is a necessary virtue when it comes to assessing active investing performance. Nevertheless, with the weight of relentlessly aggressive Fed accommodation about to be lifted, it seems a good bet that the most successful strategy of the past seven years–buy and hold–won’t be repeated going forward.