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In September 2023, University of Colorado Boulder alumnus Sepp Kuss won the Vuelta a España (Tour of Spain), one of cycling’s three grand tours and a lesser-known cousin of the Tour de France. Kuss’s specialty lies in riding in the high mountains, a skill he demonstrated during the grueling, three-week 1,960-mile stage race across Spain, as he fought for victory. Some days the race consisted of long flat sections, but things got interesting when the road got steep. Without the steep climbs, Kuss would not have been able to break away from the pack and showcase his strengths.
The macroeconomic environment since the Federal Reserve began their most recent hiking cycle has been like a challenging, high altitude, steep-gradient climb in a cycling race. Higher interest rates put greater pressure on companies to optimize their capital structure and manage debt. Active managers must sort through the wide dispersion of companies who have either successfully navigated the higher rate environment or been crushed by the steep grade of rising rates over the past two years.
Correlation of stocks to their index has decreased, meaning that active management’s role in evaluating unique company risk has increased in importance. In periods of highly correlated bull markets, passive strategies or incompetent active managers can hide, similar to a struggling cyclist coasting in the draft of a big group. Additionally, correlation typically rises in periods of crisis valuation drawdowns, such as March 2020. In these periods, active management is highlighted in the portfolio for its downside risk mitigation function.
In the past decade, easy money has benefitted both public and private markets. Correlation was higher, making it an easy decision to take beta risk through broad market indexes. During that time, businesses found it easier to borrow and grow compared to the current interest rate environment. This created an environment where a CFO who started their career in 2009 may realize, now 15 years later, that many of their business operations are not as effective given current borrowing costs.
Without discounting the fact that this is the most aggressive monetary tightening policy in recent history, it is fair to deduce that many companies have avoided further scrutiny of their stock prices due to the extended lifeline of easy money. Higher costs of capital are more intensely felt for smaller businesses, who generally rely more on short-term borrowing and floating rate loans to operate. A challenging economic environment creates a scenario where quality businesses and investment managers with dependable leadership have the chance to show their worth.
Active managers in public equity have a great opportunity given lower single-stock correlation and the potential for a higher for longer rate environment. While the S&P 500 has benefited from index concentration, given the recent performance of NVIDIA, Apple, Amazon, Google, Microsoft, Tesla, and Meta, this is not always the case. Just a few years ago, shares in GameStop and other meme stocks traded erratically, leaving small cap index investors without a guiding voice for their portfolio. Index investors, for better and for worse, are in for the ride. As we have seen over the past few years, when the road gets steep, we find out who the true winners are and who has just been coasting in the pack.
Peter Girard is a manager and a member of the Due Diligence Group and the Capital Markets Team. The Due Diligence Group is responsible for sourcing investment managers as well as monitoring recommended products and strategies. Additionally, this group utilizes both quantitative and qualitative analysis while evaluating performance, understanding return attribution, and meeting with management teams. Peter also supports the Capital Markets Team by providing research on the capital markets and performing asset allocation studies. In addition to his due diligence and capital markets responsibilities, Peter focuses his efforts on projects for Innovest’s nonprofit, family, and individual clients.
Austin Cleveland is an analyst assistant on the Retirement Plan and Research Teams. He provides support to Innovest’s retirement plan clients and has coverage on various investment products across asset classes as part of his research responsibilities. https://www.innovestinc.com/austin-cleveland
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