A bigger role for active strategies

Actively adjusting to the new regime

Financial markets are adjusting to the new regime of greater volatility, uncertainty and divergence in market performance. A more dynamic portfolio approach is needed – and if investors have confidence in their ability to pick good managers, active strategies should play a bigger role in portfolios today, in our view. Active strategies include dynamic approaches to indexing.

Static asset allocations – or set-and-forget portfolios – are a reasonable starting point but we don’t think they will deliver as in the past. The era of ultra-low interest rates is in the past and future expected returns look less attractive. We believe excess returns over cash will be much lower for static exposures as a result.

Macro uncertainty has ballooned since the pandemic struck – and dispersion of returns has increased. The new, more volatile and more uncertain regime has led to heightened dispersion in some markets. There’s less conviction about the path ahead – the range of estimates on key macro data like inflation has grown wider. The range of U.S. stock returns has grown markedly wider. That means there are more opportunities for skilled managers to find and deliver active returns, in our view. We define active returns as above-benchmark returns that can’t be explained by static exposures to macro and equity style factors.

We find that alpha-seeking managers acting more frequently on their insights may be better rewarded in this new regime. Does that mean skilled managers have added more active returns? Our research suggests so, even after excluding the pandemic’s most volatile periods.

Professional managers as a group have not become more skilled at delivering active returns overall – but we do find today’s environment is more conducive for skilled managers to deliver more active returns. The top-performing developed market (DM) equity and hedge fund managers have been delivering more active returns by exploiting the new regime’s uncertainty and dispersion. We assume a fee for active returns in DM equities based on a manager fee survey, as fees can vary and be negotiated. For hedge funds, active returns are net of fees, as overall hedge fund returns are reported net of fees.

All this only matters if investors can reliably pick top managers. Why? Delivering top-ranking active returns consistently is difficult. Finding managers that do requires extensive research and monitoring, which can be costly. That’s more important now as the new regime more clearly separates the outperformers from the rest. Investors with a preference for rules-based strategies or those with a limited governance budget may choose to keep their entire portfolios in index tools.