Active managers' long spell of underperforming the market may be coming to an end
For years, actively managed funds have gotten a bad rap. Not only have they been generally unable to match or outperform their benchmarks – partly due to costly behavioural mistakes – but they’ve also cost investors more in fees compared to their passive index-tracking counterparts.
The rational response among many investors, therefore, has been to put more of their investments in passive ETFs and mutual funds, which have been able to fetch better returns. But as conditions in the financial markets turn in the face of the new normal triggered by COVID-19, active long-only equity managers may finally be getting their season in the sun.
In a piece published by the CFA Institute, C. Thomas Howard and Jason Voss cited numerous academic studies to suggest that the current environment is a favourable one for stock-pickers based on a measure called Active Equity Opportunity, or AEO.
“The active equity opportunity (AEO) estimates the impact of market conditions on stock-picking returns by measuring how investors are driving individual stock return dispersion and skewness,” they said. A higher AEO, they noted, indicates a higher likelihood that active managers’ high-conviction picks will outperform the benchmark.
They listed four components of AEO that must be calculated in descending importance:
- Individual stock cross-sectional standard deviation;
- Individual stock cross-sectional skewness;
- CBOE Volatility Index (VIX); and
- Expected small stock premium
Based on data from Morningstar and AthenaInvest, they found for the months including December 1998 until February 2021, the average beginning-of-the-month AEO score was 40, with values greater than 40 indicating a better environment for stock picking.
“During the nearly 25 years under review, the 1998–2006 and 2008–2010 periods favored stock picking,” they said. “For much of the previous 10 years, stock pickers faced strong headwinds, which in part explains passive’s recent growth at active’s expense.”
From 2011 until 2019, AEO was mostly below average, hitting bottom at 18 in mid-2017. Based on another study going back nearly 50 years that was conducted by Anna Helen von Reibnitz, mid-2017 AEOs were some of the lowest in half a century. But AEO has spiked since late 2019, and now sits at twice the 40-point average.
The current recessionary environment is another possible tailwind for active managers. Based on data from the National Bureau of Economic Research, they highlighted periods of recession that have occurred since December 1998, including the latest one that started last year and has lasted up to today.
“We are currently in a recession, until NBER says otherwise, that is accompanied by higher AEOs,” the two said. “This should be ideal terrain for stock pickers.”
