“In a recent meeting, a client asked me a common question: Since I started my career, I have heard the bullish arguments in favour of active managers, but it still hasn’t happened. Will active managers ever outperform, someday?”
Text: Rob Almeida (Global Strategist at MFS Investment Management) •
Many investment professionals who started their careers after 2008 likely identify with this sentiment. The current market reflects this feeling: passive strategies now account for more than 50% of the US equity market, a significant increase from the early 2010s, when they amounted to less than half that level. In practice, the dominance of passive investing could be even greater if we include the assets of closet indexing portfolios (theoretically active management funds that closely track an index) and other strategies designed with minimal tracking error.
Will active managers ever outperform? If a picture is worth a thousand words, then the collective response of the broader market is “no.” If that were the case, then a fundamental shift has occurred. The reason must be one of two things: either there has been a permanent erosion of investment skills, or the market inefficiencies that once spurred active management have completely disappeared.
WHAT IS ALPHA: SKILLS AND BREADTH
To understand alpha, one must review the fundamental principle of active management. This principle stipulates that a manager's information ratio (a measure of added value) depends on their information coefficient (which represents their skill) and the square root of investment opportunities (which represents the breadth of opportunities). In short, alpha is generated by a combination of stock selection and variation in stock returns.
EROSION OF SKILLS OR LACK OF MARKET BREADTH
Historically, portfolio managers’ skills, like other human abilities, were governed by a normal distribution, with a range of returns around the market mean. Since the early 2010s, this distribution has become increasingly skewed, with few active managers systematically outperforming their benchmarks. Critics often attribute this to a structural erosion of skills, arguing that technological advancements have eliminated the information advantages that some once had.
The effects of a zero-gravity atmosphere are similar to those of an economy with zero interest rates. With other rates, many investment and business projects would have already been liquidated
While this argument seems plausible, as technology has undoubtedly made it much easier to access information, I believe it is more of a coincidence than a causal relationship. Information is nothing more than an aggregation of data or facts. Wisdom, the main component of a manager's skills, is a product of experience and deep knowledge. It represents the ability to synthesise, infer, and make good decisions based on aggregated information. As the English poet William Cowper once said: “Knowledge is the food of the soul, but wisdom is the flavour.” Although the information gap has narrowed and perhaps even closed, the wisdom gap remains significant. The ability to transform knowledge into useful information is surely still broad, despite the questionable profitability of active managers over the last 15 years.
If it is not due to an erosion of skills, could it be due to the breadth of opportunities? The dispersion of stocks or market breadth is cyclical in nature. Instead of delving into charts that show idiosyncratic risk measures below normal or high levels of correlation between pairs of stocks due to external factors, this concept can be explored through a more intuitive, albeit perhaps unconventional, lens.
SPACE TRAVEL AND MARKET BREADTH: A REMARKABLE PARALLEL
Let us think of astronauts in space. In a zero-gravity environment for an extended period, their muscles begin to atrophy; their bodies require a load, and without it, they lose bone density. The effects of a zero-gravity atmosphere are so serious that when they return to Earth, astronauts must be lifted and carried out of the return capsule, and then they must undergo intense training for weeks to repair the atrophied muscles.
Even if central banks try to lower rates again, alarming fiscal deficits and the reactivation of the fixed-income market could act as a new force of gravity this time
Interest rates play a role similar to gravity in the economy. They act as a resistance to load, creating disparities in returns between the fittest companies and those less fit. When the demand for capital exceeds the available supply, or when there are more borrowers than savers, the cost of capital rises and increases the rate at which potential investment ideas are eliminated, discarding less viable projects. Conversely, when the supply of savings exceeds the demand for capital, interest rates fall, increasing the attractiveness of various investment opportunities. This dynamic helps society reach equilibrium by allocating capital to projects with genuine economic utility. Without this resistance mechanism, akin to the atrophy of muscles in a zero-gravity environment, capital is not allocated according to the utility it generates.
While below-average interest rates during the 2010s were surely justified by an excess of savings and a decline in the demand for productive capital, central banks distorted the natural rate of the capital market to historic lows. This was further exacerbated by trillions of dollars in fiscal stimuli during the pandemic. This frictionless period, instituted by policymakers, prolonged the life of some investment projects and businesses that would otherwise have been deemed unsustainable or completely liquidated. This artificial prevention of resistance and, therefore, of capital loss suppressed market breadth, in our opinion. From this perspective, the tribulations of qualified active managers have been cyclical and possibly artificially imposed.
LOOKING TO THE FUTURE:
OPPORTUNITIES RETURN
While we do not have data on the future, several factors point to a possible change. Companies now face much higher costs for labour, capital, and goods than in the 2010s. Even if central banks try to socialise capital losses with further interest rate cuts, alarming fiscal deficits and the reactivation of the fixed-income market could act as a new force of gravity this time.
Things are very different from the 2010s, and these changes will lead to divergent economic and operational outcomes for companies. Companies that offer products or services that customers truly want and need may navigate these changes better by raising prices or gaining market share. However, companies whose offerings become obsolete due to new competitors and artificial intelligence will face a different reality. This divergence could lead to an increase in market breadth and could alter the current bias in the profitability of active managers. ♦