In the age-old simplified competition between active and passive investments, the former generally got the upper hand in 2020. What does this tell us about the current environment for equities and the positioning of our Multi-Asset funds?
Over the year, as the chart below shows, actively managed funds in aggregate outperformed passives in all equity markets apart from the US, driven – particularly in the second half – by a strong return of the small-cap premium and a rotation into cyclicals on the back of positive vaccine news. For the most part, US equity performance was dominated by a few mega-cap tech companies, so passives continued to outperform, but, even there, this trend was starting to reverse in the latter part of the year and into 2021.
Despite a good 12 months for active management, the argument for passives has been gathering pace in recent years, with performance – skewed by that US mega-cap effect – providing fuel for the tracker lobby to proclaim the superiority of its wares.
We go back to the 2015 ‘great fund debate’ between Vanguard founder Jack Bogle and stockpicking advocate Jim Grant as the culmination of what, for us, has always been an ultimately fruitless battle between active and passive. To recap, Bogle’s case centred on the idea that investment returns are largely determined by cost and it therefore stands to reason that lower-fee trackers will produce superior performance. He also focused on the efficient market hypothesis – that stock prices reflect all relevant information all the time – and expressed surprise the index tracking market is not far bigger given that, for him, active management is a zero sum game: for every manager that beats the market by 2%, there is one that underperforms by the same amount.
Grant, meanwhile, similarly talked up his own book and said there are plenty of opportunities for professional investors to add value via active management. At the end, the debate was considered a split decision according to a Wall Street Journal report the next day.
We draw a few conclusions from all of this. First is that while the zero sum game description has looked like a fairly accurate assessment in the US, over recent years at least, the same is not true outside this market and even there, as stated, it looks like the story might be starting to change. Second, is to reiterate Grant’s point that there are chances for professional fund managers to add value. We suggest the data show that for patient investors like us, there is enough dispersion in returns to identify managers’ skill and select those who can outperform over the long term. A zero sum across whole markets perhaps, but not if you can avoid the underperformers.
If we look at 10-year annualised returns from UK equity funds in the chart above, for example, the FTSE All-Share has produced an average annual performance of 5.6% over the last decade. While there are plenty of active funds below that level, there are far more above it. What we can also say with certainty is that there are no broad passive funds above that line (of the two, one is a FTSE 250 tracker and the other a specialist SRI offering).
To find these long-term active winners, we look for various characteristics, and a core one is that while we believe consistency of performance is ultimately impossible over every time frame, consistency of process is a must. We tend to favour fund managers who mirror our own patient approach, showing clarity and consistency of process plus courage and conviction in executing it. We need to be confident that if we select a fund to fulfil a particular role for us and our clients, the manager will stick to his or her process whatever the market backdrop.
Given the importance of style, we do not believe a uniform screen is appropriate for every market, particularly as performance is usually a major factor in any thinning exercise. While value has staged a recovery in recent months, for example, growth has clearly outperformed over the last few years, so filtering most markets by the usual three-year return would give little more than a selection of growth funds at present.
Our fund selection includes a major quantitative element, but it is important to tailor peer groups and compare funds against relevant benchmarks, which can be as simple as value against value and growth against growth. We combine this work with qualitative assessment, looking at factors such as style, market-cap bias and assets under management, and two of our key criteria are downside protection and metrics such as the information ratio, which can help give us an indication of the all-important manager’s skill.
To offer a few examples of long-term winners from the Multi-Asset Active range, we highlight Lindsell Train UK Equity, with manager Nick Train typifying a low turnover, consistent approach who never deviates from his quality growth bias in seeking brands that survive and thrive over many others. Moving to the other end of the spectrum stylistically, JOHCM UK Dynamic is a value fund, with manager Alex Savvides equally steadfast in applying his process and currently seeing ample opportunities in the UK owing to Brexit concerns abating and under-ownership of the market by the investment community. As would be expected, Savvides’ contrarian style has been rewarded in the strong value rally since vaccines were announced in the autumn of 2020.
The strong 2020 for active management is evident from the fact that all of the Liontrust Multi-Asset Active funds produced excess returns over their Multi-Asset Passive equivalents. Beyond the small cap and value factors, overall volatility in markets has been a driver for active dominance. Most of our calls worked well in a solid period for equities overall, and in the few areas that had a poor 2020, such as property and alternatives, our funds have limited exposure. The UK was a clear outlier in terms of equity returns, dragged down by a combination of Covid-19, Brexit and exposure to weaker sectors such as energy and financials (and less exposure to tech). But our fund selection was positive – with names including Artemis Income as well as Lindsell Train – and this helped offset the market’s overall underperformance.
Looking to the rest of 2021 and beyond, we expect volatility to continue, which should provide a good backdrop for active managers, but the key questions to consider are whether the recent value rotation will continue, as well as the possible impact of rising inflation. With economies starting to reopen, or at least preparing to do so, value and cyclical stocks are leading the way so far in 2021, but it is always difficult to call a definitive change in market leadership. We urge against attempts to time the market like this and prefer to maintain diversified portfolios throughout the cycle, albeit with a tilt towards value and small caps more recently.
Covid-19 and the accompanying lockdowns have helped technology companies, particularly those involved with social media or online shopping, as millions of people have been spending more time online. We are not predicting a huge decline for these tech giants, but it is not too much of a stretch to suggest some pullback for their earnings in 2021 as people are able to return to the high street and even go on holiday abroad.
Value as an investment style tends to be linked to economic, commodity and consumer recovery and is also a good option in inflationary environments. To us, this would suggest markets such as Europe and the UK have better profiles for this year than the US. Both are also relatively cheap, with company profits recovering from a low base, while the US remains expensive in many areas as it continues to soak up speculative money from sources such as venture capital and special purpose acquisition companies (SPACs).
Beyond Europe, we would also expect Japan, Asia and emerging markets to benefit from global recovery as major exporters, particularly with so much stimulus money still in the system. As evidence of all of this – with a usual warning about not reading too much into short-term trends – the US has been lagging so far in 2021.
In light of these shifts, we have reduced our bias towards quality growth and added to value and small caps across UK and US equities in the Multi-Asset Active funds. In the US, we have reduced AB American Growth and added Ossiam Shiller US Sector Value. while in the UK we have taken some profits from Lindsell Train UK Equity after a good 2020 and added to the more value-oriented JO Hambro UK Dynamic.
Key Risks
