Be it resolved that security selection is dead. Macro forces drive portfolio returns.”
This was the resolution for the Alternative Investment Management Association’s (AIMA) annual debate. It reflects what I’m increasingly hearing – it’s a tough environment for active managers due to higher correlations between stocks, increased volatility and the popularity of exchange-traded funds (ETFs).
There’s no debating the fact the market is hard to beat. In a 1991 article in the Financial Analysts’ Journal, William Sharpe – winner of the 1990 Nobel Memorial Prize in economic sciences – outlined how active management is a zero sum game. The return of the average actively managed dollar (before fees) must equal the market return. For every winning dollar, there’s a losing one. Given that fees for active management are considerably higher than indexing, the stock picker’s challenge is obvious.
Last year Charley Ellis, a long-time consultant to the asset management industry, wrote in the same publication that it’s getting even harder as more talent, armed with more resources, pursue the same goal. But is it worse than in the past? To answer that, let’s address the new challenges.
The correlation between individual stocks and the overall market has increased. Since 2007, the implied correlation of the S&P 500 has risen from the 40-to-50-per-cent range to 60 to 70 per cent. In other words, there are more days when it seems like stocks of all types are moving in unison based on macro-economic news. Managers are left to wonder if it really matters which oil or consumer stock they own.
But if you assume that stock prices eventually reflect their underlying value based on dividends and growth, then an undiscerning market is an opportunity for long-term, valuation-driven investors. When a multibillion-dollar “sell” program takes down a stock, it’s a gift for a manager looking to buy.
Increased market volatility is certainly wearing on managers and clients, and encourages hyperbole at cocktail parties and in the media. But large daily moves have nothing to do with generating long-term returns. Today’s price only matters if you have to buy or sell.
As for ETFs, their growing popularity makes the investing environment more fertile. The bigger share of the market that’s insensitive to individual stocks’ valuations, the more pockets of opportunity there will be for managers with a strong discipline (and stomach) around price.
In my view, the current challenges to active management are trivial compared to Mr. Sharpe’s undeniable math and Mr. Ellis’ competitive reality. Beating the market is a tough gig, but all is not lost. If we do a breakdown of the players in Mr. Sharpe’s zero sum game, it becomes evident there are some who are not seeking above-index returns and others who are structurally incapable of doing so. These players help fill the game’s loser pool, from which true stock pickers can generate their winnings.
I’m referring specifically to dollars that are stuck in the middle between indexing and active management. Not “clowns to the left of me and jokers to the right,” but good managers whose mandates don’t let them stray far from the market benchmarks for reasons of risk management or marketing. They can’t be more than a certain percentage overweighted or underweighted in a stock or sector, and/or are constrained by the type of stocks they hold and style box they’re in.
Size can be another constraint, particularly in Canada where managers of large funds can only build meaningful positions in the top 60 to 80 stocks. And when managing their portfolio, they have limited ability to move around. They’re often forced to pay a premium (or sell at a discount) for large blocks of stocks, and can take weeks or months to acquire (or sell) a full position.
Also stuck in the middle are funds and structured products where investment decisions are ruled, or overruled, by risk management systems. Their unique objectives (principal protection being one) require that stocks be sold when prices are down and conversely, encourage more stocks be held when prices are up.
So while the challenges are there, stock picking is no closer to the grave. The current concerns around correlations, volatility and ETFs are more of an opportunity for portfolio managers than an impediment.