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Sally Campbell, Executive Director, JBWere, explains why investors should stick with their active fund managers, despite a period of underperformance by some.
The debate about active versus passive investment strategies ebbs and flows. Does that mean there’s no role for active managers in your portfolio?
Not all market conditions are suitable for active managers. Active managers are typically the first to admit that themselves. Markets driven by momentum, “irrational exuberance” or other external factors (for example the “risk on” impact of quantitative easing) are all environments where fundamental active managers are likely to struggle.
Let’s look at the detail before we sell our active managers and move to 100% passive. Whilst there’s a broad range of investment styles active managers undertake, a majority typically undertake fundamental analysis to measure the value, quality or earnings potential of a company before investing. With unprecedented levels of interference in the global economy by central banks, it’s unlikely to be surprising that equity markets have been driven more by macro issues than stock specific issues.
To support this view, we look at the 56.6% return from the MSCI World Index for the three years ending 31 December 2014. This is a time when global real GDP growth has been in the range of 2-3%, solid growth, but not boom times.
Let’s break the return down further. Equity returns are made up of three components, dividend yield, earnings growth and valuation expansion or contraction. Over the last three years, the Price-Earnings (PE) ratio of the index has expanded by 37%, which means around two-thirds of the return from equities has come from valuation/PE expansion, with earnings growth representing less than one-third of the total returns.
Taking this another step further, Epoch Investment Partners, a global equity manager recently undertook a study of US equities. The manager broke the S&P 500 index into two buckets, those companies with positive 12-month trailing earnings and those companies with negative earnings over the prior 12-month period. Over the last 12 years, this analysis found the share prices of companies with positive earnings returned more than 200% over the period, whilst those companies with negative earnings fell 20%.
Amazingly, for the period from 31 December 2011 to 30 August 2014, companies with negative earnings gained 95% whilst stocks with positive earnings rose only 68%. Is that sustainable? Is this an environment where we expect our active managers to outperform?
Interestingly, since quantitative easing in the US ended, we have seen the most recent trend revert to long-term trends. Stocks with positive earnings are generating a positive return, whilst stocks with negative earnings are declining.
Ultimately we invest in active strategies to generate outperformance after all fees. But it is important to accept that whilst outperformance is a valid objective long-term, there are periods where market conditions won’t always suit a fund manager’s fundamental approach to stock selection.
For those of you that don’t want to be exposed to the potential for active managers to underperform, there are a range of passively-managed investment options available across all asset classes. You need to know that passive strategies will also underperform the market (after taking into account management fees – albeit lower than active fees) and they offer no protection during periods of market weakness. Active managers in general have performed better than the benchmark during periods of weakness.
In short, we don’t believe now is the right time to sell your fundamental active managers to move to a passive strategy.
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