The high turnover we have seen since the vaccine announcement last November has allowed active fund managers to benefit greatly from their stock picking capabilities, combined with a disciplined approach to valuation.
The question remains, where can we go from here?
Over the past decade, active managers have faced various major headwinds, one of the most important being unprecedented levels of market concentration. In fact, this factor, along with the rise of passively managed funds, is one of the major contributors to the disruption of the active fund management industry.
The onset of the pandemic has dramatically increased these headwinds to historic levels.
When it comes to market concentration, if one manager didn’t have exposures to the biggest names in tech in 2020, one of them would likely be left behind. A limited number of stocks moving the markets creates a difficult environment, even for qualified stock pickers. In this case, it was particularly difficult for managers to outperform with any type of valuation discipline. The attached graph shows how concentrated the markets have become in 2020, even surpassing the concentration encountered during the dot-com bubble in the early 2000s.
Since the first news of effective COVID vaccines came out, the concentration has dropped, although it remains at a historically high level. Additionally, we are seeing increasingly scrutiny from several governments challenging the dominance and monopoly power of these mega-cap tech companies. This is believed to give active managers an increasingly favorable opportunity to generate excess returns through stock selection, as the number of stocks outperforming their benchmarks increases.
Just like market concentration, trends in cross-sectional volatility and cross-sectional correlations show encouraging signs for active managers. As the correlations decrease, the extent of idiosyncratic opportunities increases. An environment in which cross-sectional correlations decrease and cross-sectional volatility increases, would be the ideal scenario for active managers.
The early 2000s is a prime example of this, with an extended period of low correlations and higher volatility that has proven to be a very effective stock picking environment. Fast forward to 2021, the gradual return to normal has brought these two metrics to tailwind for active managers. With the aforementioned scrutiny by governments of mega-cap technology, renewed commitment to supportive fiscal policy, and central banks pledging to remain accommodative for the foreseeable future, this trend is expected to continue.
Correlations reached an all-time high between 2017-2020, which coincides with a particularly difficult period for active managers.
The recent drop in correlations reflects an exit from the market crisis and a return to the bottom-up drivers of stock market performance.
Americans are sitting on about $ 2.2 trillion in surplus savings
The trend in cross-sectional volatility is also on a positive trajectory, improving opportunities for returns.
Interest rates were one of the main factors in the weakening of the fortunes of active managers in the late 2010s and the resurgence of the recovery linked to COVID.
The consensus has been that for the fortunes of active management to turn, interest rates don’t need to rise, they just need to stop falling. As economies continue to reopen and spending increases, inflation has become a concern. In fact, the month-over-month rise in consumer price index inflation in the United States was the largest since 1981.
10-year US Treasury yields hit all-time lows in 2020 and Americans are sitting on about $ 2.2 trillion in excess savings. Supply shortages have spread from construction and lumber to technology and semiconductors.
These effects have and are likely to continue to fuel near-term inflation fears, which have already pushed up 10-year Treasury yields in the United States. This new environment has had a direct impact on tech names, as growth companies that rely on longer-lived earnings are disproportionately affected by higher discount rates. Even if this short-term spike in inflation turns out to be temporary, the economic recovery is underway and is likely to continue given the strength of consumer balance sheets.
In other words, without another unpredictable deflationary shock, interest rates should not fall.
The opportunities become more pronounced coming from extreme starting points.
Valuation spreads, fiscal / monetary policy and market concentration are all returning to historically high levels. These factors, combined with declining correlations and above-average volatility, contribute to the belief that the active management environment has improved significantly and supports managers’ ability to generate returns through security selection. .
The author and the company have obtained the information in this article from sources they believe to be reliable, but have not independently verified the information in this document and, therefore, its accuracy cannot be verified. guarantee. The author and the company make no warranties, representations or warranties and accept no responsibility for the accuracy or completeness of the information contained in this article. They have no obligation to update, modify or amend this article or otherwise notify readers in the event that any matter stated therein, or any opinion, projection, forecast or estimate set out for the change or becomes inaccurate thereafter. BOV Asset Management Ltd is authorized to provide investment services in Malta by the Malta Financial Services Authority.
Christian Buhagiar, Portfolio Manager, BOV Asset Management Ltd
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