ACTIVE MANAGERS RALLY TO STRIKE AGAINST DRONES / THE FINANCIAL TIMES COMMENT & ANALYSIS

December 8, 2013 3:59 pm

 

Active managers rally to strike against drones

 

By John Authers

 

Passive managers have dominated sales for five years

 

 

For five years, the story for investment managers has been of The Triumph of the Drones. Passive investment managers have dominated sales, far outstripping active asset managers. Exchange traded funds, still overwhelmingly passive vehicles, have made life even harder for active managers.

 

Meanwhile, active managers – whether working for regulated groups or for hedge funds – have not helped their cause by failing to beat their benchmark indices. Small wonder investors balk at paying their management fees. But now, active managers believe, it is time for the Revenge of the Stockpickers.

 

The excuse has been plain. The panic that followed the Lehman bankruptcy made everything fall at once. No chance to outperform there. But since then, the recovery has been wary, following a pattern of “risk on-risk off”. When macro conditions seem less alarming, risk assets rise together. When the global situation looks more threatening, generally because of political developments in the US or the eurozone, everything falls together.

 

This is not just true of different asset clases. Even the performance of stocks within the same asset class has been abnormally correlated. Active asset managers spend much money spotting and exploiting small discrepancies between the prices of different stocks. With high correlation, anomalies go uncorrected, and the money spent on spotting them is wasted – at least in the short term.

This is a problem for stockpickers, but it has broader ramifications. Company treasurers, for example, find their cost of equity set by factors far beyond their control, and often at levels that make no sense for their company.

Correlation is measured in various ways, but the picture is consistent. Andrew Goldberg of JPMorgan Asset Management in London, points to research going back to 1926 which tracks the correlation of every large-cap stock with every other. It tracks a dauntingly large series of pairs.

The average over this entire period was 0.269. In other words, differences in the performance of one stock are sufficient to explain 26.9 per cent of the difference in the performance of any other stock. This measure reached 0.63 in the quarter after Lehman. The latest measure is just over 0.36, and it has been as low as 0.32.

To take another measure, Goldman Sachs monitors correlations between stocks in the Stoxx 600 index of European stocks, and for the US S&P 500. On a three-month basis, European correlations reached 0.6 in late 2011, thanks to the eurozone crisis. They are now back at a far more manageable 0.2. The equivalent exercise for the S&P, where correlations were even higher thanks to the influence of banks, saw correlation reached 0.74 after the downgrade. It now stands at 0.27.

Morgan Stanley’s Adam Parker measures idiosyncratic stock risk – the extent to which a stock moves due to its own individual factors rather than the market. On this measure, individual stock risk is at its highest since the crisis.

All of this is symptomatic of the world’s gradual emergence from fear-driven conditions. It should be good for active managers. As Mr Parker points out, equity-based hedge funds perform better when idiosyncratic risk is rising. When stocks are not all moving in the same direction at once, there should be far more to be gained by picking stocks.

There are signs that this is happening. According to Hedge Fund Research of Chicago, equity hedge funds lead all hedge fund strategies for the year so far, with a gain of 12.9 per cent. This is their best since 2009 – but still far behind S&P 500 trackers, up about 30 per cent for the year.

This is the active fund management community’s opportunity to reassert itself after some tough years in which it has been losing the argument over indexing. But there are still problems.

One issue, raised by Christian Mueller-Glissmann of Goldman Sachs, is that volatility is also down. When volatility was wild, correctly calling the direction of the most volatile stocks, even if they correlated with the market, allowed big outperformance; selling short bank stocks ahead of the crisis, and then buying them when confidence began to return in 2009, would have been a great way to earn money, for those who had the necessary stomach. With less volatility, significant outperformance is harder.

A further issue is that reduced correlation merely gives stockpickers an opportunity to show their worth. It does not guarantee it, and it also allows them to underperform by more. But unless markets lapse into a new crisis in the new year, the logic is that there is money to be made by those who spot mispricings.

Active managers’ challenge is to find them. This may be their last chance to defeat the Drones.


John Authers is the FT’s senior investment columnist

 

Copyright The Financial Times Limited 2013.