John Lynch Chief Investment Strategist, LPL Financial
Active management may be poised for a comeback. During the past several years, it’s been difficult for active managers to outperform equity benchmarks. There are a number of reasons for that, including the strength of the market, market distortions from central bank bond purchases, and high correlations between stocks. However, the tide has started to turn, which we believe sets active managers up for better relative performance opportunities in the coming years.
MANAGER CONDITIONS ARE IMPROVING
Several of the market conditions since the financial crisis that have presented headwinds for active managers are starting to abate. One is the ultra-supportive monetary policy environment. As the Federal Reserve (Fed) bought trillions of dollars in bonds (so-called quantitative easing, or QE), interest rates fell to artificially low levels and stock prices climbed despite relatively flat earnings. As the Fed has started tightening its policy, the central bank–driven market has become more fundamentally driven. A more traditional business cycle where fundamentals (earnings, sales, cash flows, etc.) propel stock performance should favor active strategies going forward, a theme explored in our Outlook 2018 and Midyear Outlook 2018 publications.
Also note that companies respond differently when the economic environment gets tougher, as it may do over the next couple of years. Because of this, companies’ results and stock performance tend to disperse, creating a favorable condition for active managers.
Thirst for Yield
One of the implications of QE was that market participants increasingly looked to replace bond income lost because of depressed interest rates with dividends from stock holdings. When yield became a primary determinant of which stocks did well and which ones didn’t, the fundamental research employed by many active managers became less effective. When fundamental factors such as company earnings, cash flows, and valuations drive stocks, active managers tend to do better. When macroeconomic factors such as interest rates drive stocks, active managers tend to struggle. Now that the Fed has tightened policy, and interest rates have risen, active manager performance has more opportunity to improve.
In addition, rising interest rates increase and help differentiate companies’ costs of capital, which makes companies’ capital allocations more important, another characteristic of a fundamentally driven market.
Stocks have tended to move together in this macroeconomic environment, evidenced by elevated intra-market correlations [Figure 1]. Stock pickers struggled to differentiate themselves during this time. This statistic has seen its ups and downs in recent months; however, since the fourth quarter of 2016, correlations of S&P 500 stocks to the index have generally fallen, giving active managers more chances to differentiate themselves from the indexes they are trying to beat. Put another way, more dispersion among individual stocks makes it easier to find winners, giving managers a bigger pond of potential outperforming stocks to fish in.
In late 2017, correlations between stocks reached some of the lowest levels of the past two decades and they remain well below the 10-year average on a rolling 3-month basis.
Big Gains Tough to Match
Active managers tend to struggle to outperform their equity benchmarks when stocks perform their best, i.e., when valuations are rising. Higher stock valuations were a primary goal of central banks’ stimulus efforts following the financial crisis (and delayed the return of the business cycle by reducing the market’s interest in company fundamentals). We can see this by plotting…