Active management: the value of a systematic, bottom-up investment approach

Recent analysis concluded that there is a compelling case to be made for active strategies. The caveat, however, is that for an active strategy to outperform in today's market—which consists of a low cost environment and as access to more sophisticated products becomes democratized—it requires a systematic approach that is supported by robust quantitative capabilities paired with a bottom-up focus on value and fundamentals.¹

Over the past decade, roughly $2 trillion has rotated into passive equity and exchange-traded funds while over $1 trillion has streamed out of active strategies. Currently, passive managers control a market share of nearly 40% in the United States and 30% in Europe.² This has led advisors to believe there is absolutely no need to beat the equity markets, but simply capture the returns of the capital markets.

We believe this kind of sentiment should materialize around year eight of an uninterrupted run in the U.S. equity markets. The S&P 500 Index, which hasn't posted a negative annual return in the past seven years, has generated double-digit total returns five times since 2008, while 2009 and 2013 produced total annual returns in excess of 26% and 32%, respectively.³ Make no mistake: We believe these are the primary ingredients for investment complacency.

This sense of contentment couldn't have arrived at a worse time, as most signs point to a developing low growth environment. The Shiller P/E ratio, also referred to as a cyclically adjusted price-to-earnings (P/E) ratio, implies total returns of 6% annually over the next 10 years and the current bond yields suggest annual returns of only 2% over the same period. Yet the National Association of State Retirement Administrators cites that state pensions are expecting annual returns of nearly 8% on average, so there exists a gap between growth estimates.⁴

Investors will again become dependent on those fund managers who can produce idiosyncratic alpha, as asset owners seek to meet liabilities and retail investors fund retirement and college savings plans. But from where will the differentiated and uncorrelated return stream emerge? We believe that in a low return market, the best way to beat the benchmarks is to avoid the groupthink that fuels so many passive strategies.

Academic research has demonstrated that active fund managers who employ high active share strategies will outperform in both good and bad markets when adhering to a buy-and-hold approach.⁵  The underperformance of active managers stems from the structural decisions at the fund manager level, including asset bloat, closet indexing, and overdiversification, which translate into portfolio drag. Nearly 80% of funds, however, display ample management skill to overcome the higher fees of an actively managed strategy.⁶

There have been six periods of prolonged underperformance since 1926 in which pure value factors suffered over a business cycle.³ While growth and momentum may outperform in certain environments, mean reversion remains one of the most powerful tools investors have at their disposal. It is the potential for underperformance that creates the idiosyncratic risk that value investors can take advantage of in the first place. Since 1991, there have been four distinct windows across eight periods in which active outperformed passive strategies. Active strategies also tend to perform better when value beats growth, international equities outperform U.S. equities, and small-cap stocks are more attractive than large-cap stocks.⁷

We believe that the increasing prevalence of index funds and the growth of smart beta strategies aren't having an impact, but along with the rise of passive management has been a growing tendency of crowding into certain factors. High long-term growth, high margins, and high momentum currently sit as the top three crowded factors across regions.

The volatility and potential loss that can result from overcrowding will become more frequent and severe along with continued adoption of quantitative heavy smart beta strategies. A systematic approach is necessary for fundamental managers to capture the full breadth of the investable universe while delivering higher active share and tracking error that are attributed to outperformance. As the passive versus active debate dissolves, investors will likely be more focused on the kind of activity a particular fund manager engages in, be it strategic factor exposure, timing, or stock picking.

We believe that managers who consistently generate the idiosyncratic returns that will be so critical in a low return, high factor crowding environment will be able to demonstrate the alpha only active managers can deliver. Our analysis-driven process allows us to isolate the tails of distribution to create a target-rich environment in which we assess a company's valuation, fundamentals, and momentum. This guides us to areas of the market underweighted by those who base and fill out their models through economic forecasts or other macroeconomic factors. Our systematic, bottom-up approach generates alpha-driven trades that are completely independent of composite rankings and features all of the characteristics now in vogue as the market reshuffles amid the evolving financial landscape.

1 “In Defense of Active Management,” Bernstein Research, 2016.

2 Morningstar, as of 7/31/16.

3 S&P, Dow Jones, as of 7/31/16.

4 “Public Pension Plan Investment Return Assumptions,”nasra.org, February 2016.

5 “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently,“ Cremers and Pareek, December 2015.

6 “Is Active Management Dead? Not Even Close,”cfainstitute.org, 7/26/16.

7 “Active vs. Passive: A Three-Club Headwind,” Scott Opsal, leutholdfunds.com, July 2016.