The great rotation we have witnessed since the vaccine announcement last November has helped active fund managers to benefit greatly thanks to their stock picking abilities, combined with a disciplined approach to valuation.
The question remains, where can we go from here?
Throughout the last decade, active managers faced various major headwinds, with one of the most prominent being the unprecedented levels of market concentration. In fact, this factor, along with the rise of passively managed funds, is one of the main contributors that led the active fund management industry to face disruptions.
The onset of the pandemic drastically increased these headwinds to historic levels.
With regard to market concentration, if a manager did not hold exposures to the largest tech names in 2020, one would likely been left behind. A limited number of shares driving markets creates a difficult environment, even for skilled stock pickers. In this case, it was especially difficult for managers to outperform with any kind of valuation discipline. The accompanying chart shows just how concentrated markets became in 2020, even surpassing the concentration faced during the dot-com bubble in the early 2000s.
Since the first news of effective COVID vaccines came out, concentration has fallen, although still at a historically high level. Additionally, we see increasing scrutiny from several governments challenging the dominance and monopolistic power of these mega cap tech firms. It is believed that this gives active managers an increasingly favourable opportunity to generate excess returns through stock selection, as the breadth of stocks outperforming their benchmarks increases.
Much like the market concentration, trends in cross-sectional volatility and cross-sectional correlations show encouraging signs for active managers. As correlations fall, the breadth of idiosyncratic opportunities increases. An environment where cross-sectional correlations are falling, and cross-sectional volatility is rising, would be the ideal scenario for active managers.
The early 2000s is a great example, with an extended period of low correlations and higher volatility that proved to be a highly effective stock-picking environment. Fast forwarding to 2021, the gradual return to normalcy has driven both these measures back to a tailwind for active managers. With governments’ aforementioned scrutiny on mega cap tech, renewed commitment to supportive fiscal policy and central banks pledging to remain accommodative for the foreseeable future, this trend is expected to continue.
Correlations were at an all-time high between 2017-2020, which coincides with a particularly challenging period for active managers.
The recent drop in correlations reflects a market coming out of crisis mode and a return to bottom-up drivers of stock performance.
Americans are sitting on an estimated $2.2 trillion in excess savings
The trend in cross-sectional volatility is also on a positive trajectory, enhancing return opportunities.
A key driver for the weakening fortunes of active managers in the late 2010s and resurgence in the COVID recovery has been interest rates.
Source: Herfindahl-Hirschman Index as of March 31, 2021. Source: Factset, MSCI.Consensus has been that for active management’s fortunes to turn, interest rates don’t need to rise, they just need to stop falling. As economies continue to reopen and spending ramps up, inflation has become a concern. In fact, April’s month-over-month consumer price index inflation increase in the US was the steepest since 1981.
US 10-year Treasury yields have risen off all-time lows in 2020 and Americans are sitting on an estimated $2.2 trillion in excess savings. Supply shortages have spread from construction and lumber to technology and semiconductors.
These effects have and will likely continue to feed short-term inflation concerns, which have already resulted in rising 10-year Treasury yields in the US. This new environment has had a direct impact on tech names, as growth companies that rely on longer duration earnings are disproportionately impacted by higher discount rates. Even if this short-term inflationary spike proves temporary, the economic recovery is underway and expected to be prolonged given the strength of consumer balance sheets.
In other words, without another unpredictable deflationary shock, interest rates are not expected to drop.
Opportunities become more pronounced when coming from extreme starting points.
Valuation spreads, fiscal/ monetary policy and market concentration are all coming off historically elevated levels. These factors, combined with falling correlations and higher-than-average volatility, contribute to the belief that the active management environment has dramatically improved and favours managers’ ability to generate returns through stock selection.
The author and the company have obtained the information contained in this article from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author and the company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this article. They have no obligation to update, modify or amend this article or to otherwise notify readers thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV Asset Management Ltd is licensed to conduct investment services in Malta by the Malta Financial Services Authority.
Christian Buhagiar, Portfolio manager, BOV Asset Management Ltd