Active Investing Poised for Rebound?

Terry Flanagan

Although active investment management has not outperformed the secular bull market of recent years, data suggests that trend might be poised for a reversal.

“Active management has been a little bit mislabeled, perhaps rightfully so, based on what we’ve observed especially with the U.S. markets over the last five-year period,” Richard Yasenchak, senior vice president and client portfolio manager at Janus Capital’s Intech, said at a media briefing earlier this week. “Our research on active U.S. large-cap and global equity managers shows that past out-of-favor periods were followed by strong reversals.”

Actively managed funds still hold the majority of assets worldwide, though passive investing is gaining market share at a rapid pace. Many active managers have disappointed over recent years resulting in numerous investors steadily shifting assets to passive strategies.

According to the Investment Company Institute, from 2007 through 2013, indexed U.S. equity mutual funds and exchange-traded funds received $795 billion of net inflows while actively managed U.S. equity mutual funds experienced net outflows of $575 billion. According to Morningstar, actively managed U.S. equity funds experienced $98.4 billion of outflows while passive U.S. equity funds received $166.6 billion in 2014.

Richard Yasenchak, INTECH

Richard Yasenchak, INTECH

Many U.S. active managers underperformed in 2014: 54% within the U.S. Large Cap universe underperformed the Russell 1000 Index and 61% underperformed the S&P 500 Index.

While many active managers failed to generate excess returns in recent years, empirical evidence shows that active management results tend to be cyclical and past out-of-favor periods have been followed by strong performance reversals.

“Those who favor or re-allocate towards passive investing are making an active decision by betting that active management is going to remain out of favor,” said Yasenchak. “Our research on active U.S. large-cap and global equity managers shows that active managers tend to outperform in modestly rising markets and down markets and tend to underperform in sharply rising markets.”

He added, “It’s obvious that there are cyclical headwinds and tailwinds with both active and passive. As long as you believe in the alpha source of a manager as well as the investment process and the investment staff, then you probably would want to stick with that manager even if they haven’t done well over the last three to five years.”

Calibrating portfolio risk to become more defensive during crisis periods and more active during normal market conditions is the preferred approach, in Yasenchak’s view. Constructing a portfolio that adapts to the level of market volatility as a result of dynamic risk reduction offers the potential for a proper balance between capital appreciation and capital preservation.

“The analogy I would draw is that of a light dimmer, where we’re adjusting the portfolio in a systematic way without human involvement to levels of volatility,” Yasenchak said. “When volatility’s high we’ll reduce risk, and when it’s low we’ll be doing less risk reduction. We don’t have a forecast of whether or not stocks will outperform or underperform. That’s not what’s driving this light dimmer. It’s just based on levels of volatility in the marketplace; when volatility’s low and when volatility’s high the portfolio is systematically adjusted to different stocks.”

Intech, which manages $51 billion, has developed managed volatility portfolios that aim to achieve dynamic volatility reduction based exclusively on volatility estimates without forecasting market or stock returns.

“Our process is not making return forecast in underlying stocks,” said Yasenchak. “We do believe that it’s extremely difficult to forecast which stock will outperform on a consistent basis. We are less concerned with tracking error risk or how much a portfolio fluctuates around a benchmark than we are with having lower risk than a particular benchmark.”

Feature image by Simple Cartoon/ Dollar Photo Club

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