The U.S. stock market has advanced steadily over the past six years, a rally fueled partly by unusually accommodative monetary policy and notable for its near absence of volatility.
But while stocks in general have rallied since the economic recovery began to take hold in 2009, many active portfolio managers have struggled to deliver investor returns in excess of the broader market, according to a BlackRock analysis of data accessible via Bloomberg.
Many factors have been cited for this persistent underperformance, including higher fees and risk aversion in the aftermath of the financial crisis. However, another contributing factor has arguably been the Fed’s extraordinarily easy monetary policy suppressing volatility and hindering active managers’ ability to generate excess returns via security selection and portfolio tilts.
The Fed’s Next Move and the Role of Active Management
Regardless of the cause, the value proposition of active management simply hasn’t materialized in recent years. However, with the Federal Reserve (Fed) poised to begin raising rates as early as next month, investors will have to adjust to more modest returns from U.S. stocks as well as brace for heightened volatility. This could create an opportunity for an active management approach.
As Kurt Reiman and I write in our new Market Perspectives paper, “A Quantum of Solace: Can the return of volatility revive active management“, we may be entering a more favorable environment for active manager performance.
Based on our analysis using Bloomberg performance data for the S&P 500 Index back to the mid-1990s, there’s some evidence that managers’ ability to beat benchmarks comes in cycles. In fact, two somewhat interrelated variables do a reasonably good job of explaining the performance of active managers relative to their benchmarks: the annual change in volatility and the annual change in cross-sectional dispersion. (Cross-sectional dispersion measures the spread of asset returns or, in the case of the S&P 500 Index, the tendency of individual company returns to diverge from the average index return.)
As the chart below shows, we found that periods of rising volatility and heightened cross-sectional dispersion coincided with manager outperformance in large-cap U.S. stocks.
Looking forward, both volatility and cross-sectional dispersion are likely to eclipse the levels experienced in the past few years for large-cap U.S. stocks. This means that, in an environment where returns are harder to come by, investors may want to consider an active manager to source some returns and take idiosyncratic risk.
That said, we’re not advocating that investors abandon the benchmark-replicating approach.With bull market and economic expansion more mature, blending active management exposures—whether through actively-managed exchange traded funds (ETFs), multi-asset managers, traditional active equity managers or other sources—with benchmark-replicating vehicles will become increasingly important for meeting return objectives and controlling risk.
The bottom line: The more muted return prospects for traditional assets from here and rocky road ahead warrant a more thoughtful approach to blending active and passive investing in a portfolio.
(c) BlackRock Investment Management