Volatility may make individual investors uneasy, but it can bring the dispersion1 that truly active managers relish. Even though this is one of the longest bull markets on record, it has not been the typical run-up. For the first five years, earnings growth was solid, leading to significant gains. But over the past two, the factors have changed and most gains have come from price-earnings ratio2 expansion driven by eased monetary policy. As a result, equity returns have been sporadic and it is possible that many investors have not always been rewarded for taking risk.
Interest rate movements like the Fed increase that occurred in December 2016 may be the first indication of a potential opportunity for active managers, but potential volatility created by the end of the Mega-Cap3 run could make clearer distinctions between the companies that present opportunities to outperform their peers.
Passive investors meet active volatility
This shift could be a wake-up call for investors who may have come to rely heavily on passive investments. Our research shows that about six in ten investors recognize that index funds can offer market returns at a lower fee. But large numbers of investors in the U.S. see this one basic advantage and transfer greater benefits to these passive investments.4
Investors say index funds are less risky and will protect them from market losses; they aren’t and they don’t. Index funds may provide benchmark returns when markets are up, but they also deliver losses when markets are down. Investors also say passive investments are more diversified and give them exposure to what they believe are the best opportunities.4 As dispersion increases it’s important to remind investors that index funds may not offer the best opportunities; they offer a range of opportunities, both good and bad.
Investment professionals say many investors have a false sense of security about index funds and often don’t recognize the associated risks. Our research suggests many advisors use passive investments to manage fees, but they believe active management has the edge in taking advantage of short-term market movements, generating alpha and providing risk-adjusted returns.4
Volatility shines light on benchmarkers
Our research shows that advisors have another reason for implementing passive strategies: 43% say they use these funds because they believe there are too many closet indexers6 among active fund managers.7 So, if they can’t count on their active managers to justify their fee with truly active management, why not use passive investments for a much lower cost?
When it comes to selecting active managers, it’s critical to look for those who don’t try to “buy the market.” If an asset manager is going to charge an active fee, the value comes in delivering investments that are different from the benchmark. Higher volatility may mean that active managers earn their fee and add greater value to the portfolio by seeking to outperform the benchmarks. These are often the kind of managers who have a high level of conviction in their investments. They build more concentrated portfolios with the goal of allowing the performance of individual securities to drive returns.
Putting the strategy to work
The place to start is analyzing the active share7 of each strategy to help ensure that you get what you pay for from active managers. An active share above 70%–80% typically provides an indication that the manager’s security selection, not market action, drives returns.
Fee management is always an important consideration. So, should conditions improve for active managers, many professionals may begin to apply a barbell strategy to equity allocations in their portfolios. At one end they’ll pay a low fee for beta;8 on the other they’ll pay a higher fee for truly active managers to deliver alpha.9 In the middle, they’ll cut out the closet indexers who don’t deliver.
In short, it’s critical that you get what you pay for.
1 The term dispersion describes the size of the range of values expected from a particular trading strategy. It is sometimes used to measure the degree of risk associated with a particular security or investment portfolio.
2 Price/Earnings ratio, or P/E ratio, is the current market price of a company share divided by the earnings per share of the company.
3 The term “mega cap” refers to companies with a market capitalization exceeding $100 billion.
4 Natixis 2016 Global Survey of Financial Advisors – Natixis Global Asset Management commissioned CoreData Research to conduct the study of advisors in 15 countries in order to assess advisor attitudes on a range of topics such as business growth, portfolio construction (including volatility, risk and income), client service, advice and investment challenges. An online quantitative survey was developed and hosted by CoreData Research. A sample of 2,550 advisors in 15 countries including 300 in the U.S. was obtained.
5 Natixis 2016 Global Survey of Individual Investors – Natixis Global Asset Management commissioned CoreData Research to conduct a global study of individual investors, with the goal of understanding their views on the markets, investing and measuring their progress toward financial goals. Data was gathered throughout February and March 2016. The study included 7,100 investors in 22 countries including 750 in the U.S.
6 The term “closet indexing” refers to a portfolio strategy used by some portfolio managers to achieve similar returns to those of their benchmark or index, without exactly replicating that benchmark or index in the portfolio’s holdings.
7 Active share indicates the proportion of portfolio's holdings that are different than the benchmark. A higher active share indicates a larger difference between the benchmark and the portfolio.
8 Beta is a measure of volatility of a security or portfolio as compared to the market as a whole.
9 Alpha is a measure of the performance of an investment as compared against a market index or benchmark. The excess returns of an investment relative to the returns of the index or benchmark is referred to as the investment’s alpha.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Diversification does not guarantee a profit or protect against a loss.
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