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Volatility – The Mother of All Disruptions
The economic shock from the COVID-19 pandemic and subsequent market volatility that has wreaked havoc on returns recently has also presented an exciting opportunity for active stock pickers. We are arguably entering a golden period for high conviction stock picking that we have not seen in close to a decade. We have been living through a period of disruptive change unfolding across many industries in recent years and will undoubtedly see further disruption from the current crisis.
As competitive forces and technologies can drive returns down over time, it is important for businesses and investors alike to ensure they are on “the right side” of the disruption. With volatility returning to the market with a vengeance, it is once again a critical time for investors to re-examine their holdings and allocations.
The Resurgence of Active Management
International large cap equities have seen net negative flows from institutional investors in nearly every quarter in the past five years according to eVestment. Where flows have seen positive growth has been in the passive end of the market. This may seem counterintuitive given the breadth of the international equities universe and the opportunity for active managers to add value. In fact, over the past 10 years the median large cap international equity manager has delivered over 1% of annualized outperformance, whereas the median US large cap manager has trailed the S&P 500 by over 40bps annualized over the same period.
More recently there has been a notable reduction in the level of outperformance from active international equity managers with the median delivering only 56bps excess return over the trailing 3-year period. This shift may have prompted many to conclude that large cap international equities were becoming more eﬃcient and that low-cost passive options could deliver a better overall outcome. However, that conclusion may be misplaced as the reduction in outperformance seems to be more of a function of the suppressed market volatility and return dispersion in recent years.
When we look back at the 3-year annualized periods ending in 2004 and in 2006 where volatility was similarly at suppressed levels the marginal outcome for active international equity managers was not particularly dissimilar from the most recent 3-year period. However, during the spikes in volatility during the global financial crisis and subsequent European sovereign debt crisis, the 3-year periods ending in 2009 and 2012 were quite ripe for active managers as the median manager delivered over 180 bps in each period and top quartile managers delivered well over 3% in excess returns. With volatility levels now spiking again we are potentially entering an exceptional period for active stock pickers and investors sitting in low cost passive options may be leaving a very important source of excess return on the table.
Capitalizing on Conviction
Stock selection is at the core of harnessing opportunities during volatile markets. Amidst the current backdrop it is nearly impossible to know precisely the severity and duration of the COVID-19 pandemic and its impact on the global economy, but we as investors can focus on understanding the levels of stress companies in various industries and markets may face under a range of revenue scenarios given their exposures. We examine the flexibility in the cost base, end market exposure, balance sheet strength and speak with the companies to ensure we have our assumptions correct.
At Schroders, we also have the ability to leverage alternative fundamental insights through the work of our Data Insights Unit, which is providing real-time data tracking, virus modeling and footfall data in severely impacted industries to help us further refine our forecasts. This is both a labor- and time-sensitive undertaking, and having the breadth of resources to do it well is critically important.
We also believe that it’s critical to carefully manage position sizes through a framework based on forward-looking business risk. This leads to the ability to have a concentrated portfolio by stock names, but quite a diversified portfolio by risk, which helps to potentially deliver lower relative risk and overall higher portfolio eﬃciency.
We believe that maintaining low factor exposure and focusing on stock-picking translates to greater consistency of returns and less dependency on market environments, which ultimately underpins greater repeatability. These elements are arguably more important now as we expect markets to remain volatile which may result in rapid swings in market, style, sector and factor leadership.
We believe our high conviction approach provides the flexibility to actively navigate through the areas of the market offering the greatest opportunities while minimizing exposure to troubled areas. We believe that demonstrating consistent success in delivering alpha from stock selection across the broad spectrum of markets and sectors is the key to delivering over the long term through both stability and volatility.
Balancing Opportunities with Downside Risk
Volatility can be one of the biggest sources of alpha for an active manager. Investors often fail to discriminate when selling assets in tumultuous markets, a trend only exacerbated by the larger presence of passive money. For the most contentious areas – companies with significant operating and financial leverage – a “shoot first, ask questions later” mentality often pervades. In many instances, this instinct may prove correct, but in others it will prove an overreaction. Good active managers with significant resource can take advantage of these opportunities and this is what we have begun to do over the past month, particularly in the hardest hit areas of consumer discretionary.
As we move through the recovery phase, whenever that may be, equities will likely return to the key themes of low nominal growth and low interest rates. Political pressure will also diminish one of the market’s biggest recent drivers, that of the leveraged buyback. We continue to evaluate the potential to concentrate our portfolio positions toward the quality structural growth stories still able to deliver and re-rate in this environment. However, the valuations are generally still not compelling enough to become overly bullish in this area. While there is good value in some of the more troubled areas, there are also many value traps and diligent research and selectivity remain critical.
Longer term, central banks may have to grapple with an interest rate dilemma as debt piles grow and inflationary pressures reassert. Firms with durable business models and pricing power beyond their own cost inflation will likely command a premium and skillful investment managers will once again be required to identify them.
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Schroder Investment Management North America Inc.
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For more information please visit our website at www.schroders.com/us/institutional.
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