SUMMARY
- Active management has historically tended to outperform passive management during periods of rising interest rates, higher volatility and market downturns.
- A key potential benefit of active management is the ability to manage risk in a volatile environment and limit losses when the market slides.
- As the U.S. bull market ages, signs of a tipping point in favor of active management are building. Interest rates are expected to rise and market returns could become more muted after outsized gains in recent years
Why active management?
Just as markets follow cycles, different investment styles, such as active and passive investing, often take turns outperforming each other over the course of a full market cycle. Paying attention to these patterns and understanding why they occur may help improve overall portfolio performance.
With the current bull market now more than six years old, it is easy to lose sight of the advantages of actively managed stock portfolios. Active managers have generally not fared well in recent years versus passive managers. That’s partly because passive investing tends to perform better from a market trough to a market peak.
Importantly, however, actively managed portfolios often beat their respective benchmarks during market downswings and when volatility picks up. In fact, one of the key benefits of active management is the downside protection it may offer in bear markets. Skilled managers can take steps to avoid the market's weakest sectors and seek to protect gains achieved on the upswing. This is evident in the performance of active managers versus their benchmarks through the past two market cycles spanning 15 years (Exhibit A).
The tide won't rise forever
The past six-plus years have been typical of bull market environments, where many investors generally tend to do well in absolute terms – the classic "rising tide that lifts all boats."
The S&P 500 Index posted an average annual return of 16.85%1 for the six years ended June 30, 2015. During this period, U.S. stock market gains have been driven largely by macroeconomic factors, including highly accommodative U.S. and global central bank monetary policies and the ensuing liquidity tail wind. This has fostered a favorable backdrop in which many companies have found it fairly easy to grow their earnings regardless of the quality of their management, their market share or the strength of their balance sheet.
Consequently, individual stock returns have been highly correlated, making it particularly challenging for most active managers to identify opportunities to outpace their respective benchmarks or indexes.
Not surprisingly, for the period from March 2009 through June 2015, only 31% of active equity managers outperformed their benchmarks. But the stock market now appears to be at a "tipping point," where many active managers are beginning to surpass their benchmarks. In fact, a major transition may have already started: During the first half of 2015, 55% of active equity fund managers outperformed their benchmarks (Exhibit B).
1Source: Morningstar.
Signs of a sea change
Like an ocean tide, the stock market has ebbs and flows, although the timing isn’t quite so easy to predict. There are, however, inevitable cycles. Market conditions can shift dramatically to a new regime –– bull or bear market –– and then remain there for months or years.
Key factors that can signal a regime change include:
1) A major shift in central bank monetary policy.
2) Widespread anticipation of rising interest rates.
3) Increased market volatility and/or a market downturn.
4) Abnormally high or unsustainable stock valuations.
5) Reduced correlations among individual stocks.
6) Typical length of a bull or bear market.
We believe some of these signs exist now or are likely to materialize in the coming months.
Fed monetary policy change. U.S. Federal Reserve (Fed) policy is in transition. In 2014, the Fed “tapered” and ended its third quantitative easing program since December 2008. Early in 2015, the central bank changed the language in its postpolicy meeting statements, hinting that it may soon begin to raise short-term interest rates after years of historically low rates and unprecedented accommodative monetary policy (Exhibit C).
As of mid-2015, many observers expected the Fed to raise rates at some point this year or early next, depending on incoming data and macroeconomic conditions.
More muted stock market returns expected. From March 9, 2009 to June 30, 2015, the broad S&P 500 Index tripled its value, from 676 to 2063, with just a couple of brief corrections along the way. As noted, the S&P 500’s average annual return for the six years ended June 30, 2015 was 16.85%. Compare that to the stock market’s long-term average annual return of 10.1% since 1926.
Historical reversion to the mean patterns would suggest the likelihood of more modest (i.e., single-digit) annual returns in the coming years. Such a shift may have already begun: The S&P 500 Index gained 7.42% for the 12 months ended June 30, 2015, but only 1.23% for the first half of 2015.
Market valuations have climbed. The average forwardlooking price-to-earnings (P/E) ratio for S&P 500 companies had risen to 16.7 by late June 2015, compared with a 10-year historical average of about 14.1. Given this relatively high P/E ratio, and well-above-average annual returns over the past five years, few observers expect valuations to keep climbing as rapidly in the coming years.
Bull market looks long in the tooth. Consider that the average bull market over the past century has lasted 58 months and delivered a return of 188% from trough to peak. The current bull market, by contrast, was 76 months old as of June 2015, with the S&P 500 Index rising 205% over that span. This isn’t a market timing prediction, but something to keep in mind along with all the other factors.
What active management brings to challenging markets
Having considered long-term historical trends and where we are now in the context of a full market cycle, today's investors should then consider why actively managed portfolios tend to do better in more challenging markets.
- Lower correlations or greater dispersion creates opportunity. Individual stock correlations tend to decrease as market attention shifts from macroeconomic stimulus to individual company fundamentals. Being able to identify strong management teams, solid balance sheets, robust earnings growth and attractive valuations can separate strong, skilled stock pickers from the rest of the pack. As Warren Buffett once said, building on the rising tide metaphor, "It’s only when the tide goes out that you learn who has been swimming naked."
- Active managers are better able to manage risk. During the market downturns from September 2000 to September 2002 and November 2007 to March 2009, active investing strongly outperformed passive investing, largely because of the flexibility that most active managers have to adapt to changing market dynamics and manage risk more effectively. They can underweight, avoid or even short stocks that they perceive as weak or those in troubled areas of the market.
By being agile, active managers are able to avert the "bubble machines" that market capitalization-weighted indexes can become when a dominant or hot sector increases sharply in valuation, while growing into an ever-larger component of the index. As more money flows into passive funds, this problem becomes even more pronounced. This occurred with technology stocks in the late 1990s and again with financials in 2007.
Further, active managers are typically able to increase their cash holdings in an effort to minimize losses during the worst downturns. In contrast, consider the helpless feeling that an index investor might have as the whole market tumbles – and his or her portfolio along with it.
- High conviction/high active share can add alpha. The ability to express and act on strongly held investment convictions can be powerful. If you believe in the potential for skilled active managers to outperform a benchmark, then consider the possible added benefit of translating high-conviction ideas into concentrated investments in the stocks or sectors about which a fund manager feels most strongly.
This investment approach is based on the concept of "high active share." The thinking behind it is that funds with a greater-than-average variance between their holdings and those of their benchmark will, by definition, perform differently – hopefully, better, of course – than the benchmark.
The idea of high active share investing is still quite new. It was popularized by K.J. Martijn Cremers and Antti Petajisto in their 2006 paper, "How Active is Your Fund Manager? A New Measure That Predicts Performance." It is a promising area that will likely be further explored and exploited in the coming years, particularly if the market continues to evolve into a more "active-friendly" environment (as we expect).
2Source: K.J. Martijn Cremers, http://online.barrons.com/articles/return-of-the-mutual-fund-stockpickers-1420870199.
Active management at any time. Especially now.
For long-term investors, we believe the case for active management is compelling at any time, but especially when numerous signs point to a likely shift in the market that could provide fertile ground for talented, experienced stock pickers.
Over a full market cycle, investors can potentially benefit the most from capturing gains in rising markets and guarding against losses in down markets. The best active managers are able to do both and distinguish themselves by staying nimble, skillfully managing risks and effectively implementing high-conviction investment ideas. That’s the power of active management to create value for investors over the long term.
About Risk
Investments in equity securities are sensitive to stock market volatility. Equity investing involves risk, including possible loss of principal. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant.
Past performance is no guarantee of future results.
The views expressed in this Insight are those of Edward J. Perkin and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.
Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.
©2015 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414 | eatonvance.com
