HCR Wealth Advisors Discusses Active Management Alpha
We find ourselves at the end of a long growth-dominated (as opposed to value in equity market performance) business cycle, defined by sluggish economic growth and the lowest interest rates since World War II, which has served to make beacons of growth even more dear. Usually, periods of growth outperformance and business cycles don’t last this long , but we’re in an ongoing Age of Information containing the computer revolution of the 1970s to 1990s and the internet revolution of the 2000s to present. Internet and associated technology stocks have come to dominate the S&P 500:
The last significant multi-decade technological wave/period of growth outperformance in the equity market, which has many similarities to today’s Age of Technology, was the Age of Manufacturing from the 1920s to the 1940s, which saw the continued growth of oil companies, rise of automobiles, airplanes, the concept of mass market retail. Sears was the Amazon of that time period. Historically, enthusiasm around endless growth prospects of such leaders, particularly in growth-dominated business cycles, leads to excessive valuations, which then lead to poor returns in the subsequent decade.
This is why so few active managers have outperformed in recent years, the only ones who have in large cap have been overweight with tech giants or stocks that have had similar moves, which have included perhaps more valuation expansion than earnings growth. There have been other ways to outperform such as being allocated to biotech or small-/micro-cap special situations/activism. Ultimately, doing well degenerates to finding good ideas and betting big enough on them consistently to move the needle. And, it could be dangerous to try to benchmark to the S&P 500 or keep up with it late in such a growth-dominated business cycle. It’s notable that the last time active managers underperformed meaningfully for a long time in the late 1990s tech bubble, once the bubble burst and the S&P 500 began a 3-year decline, active managers enjoyed a decade of strong outperformance. For more active managers to outperform, you need a market environment with dispersion of stock returns, but with a healthy number of stocks outperforming the market average, not a narrow leadership environment like we have now. Very few active managers are willing to have positions above 5%. It helps to have some value outperformance since most active managers tend to be valuation sensitive whether they follow a value or growth style.
Having said the above, it’s useful in evaluating any strategy to think about whether the benchmark is appropriate now, what is driving that benchmark and look at a performance attribution analysis relative to that benchmark to reveal why the strategy has outperformed or underperformed. How many basis points of performance attribution did each position contribute, negative or positive, over the time(s) it was owned? Did underowning or not owning certain positions contribute negatively? Why did those positions do well? Was it sustainable earnings growth or valuation expansion?
This is important to consider because it can keep a strategy or process more grounded and keep investors from falling victim to fear of missing out . Being mindful of the drivers of returns helps put performance attribution and active manager returns in perspective. Whether talking about individual stocks or the market as a whole, returns come from 3 sources: 1) dividends, 2) earnings growth, 3) valuation changes. Dividends are the most reliable source of returns because they are often paid by companies that are mature enough to do so, in defensible-enough businesses with well-defined markets that there is unlikely to be any crazy left-field surprises that could bankrupt the business, and usually companies have to be consistently profitable over time. Earnings growth is more volatile because companies don’t grow all the time, sometimes the economy is in a recession. Also, businesses that are growing at an above-average rate tend to be in growing, less well-defined markets that invite competition, which can cause surprises. Finally, valuation changes are the least consistent—they vary depending on sentiment toward equity investing, the state of the economy, and the level of interest rates. Most weak or strong periods for equity returns are largely influenced by valuation changes, which can persist for as long as a decade. Over long periods of time, valuation changes do not meaningfully contribute to returns. Since 1930, 40% of equity returns are attributed to dividends and almost all of the balance was explained by earnings growth. Dividends had a positive contribution in all time periods.
Good ideas in picking stocks can come from exploiting inefficiencies/mispricings in any combination of these drivers of returns. At the end of the day, the investor must consistently be paying significantly less that what a stock is worth or what the market will ultimately think it is worth. There could be an above-average dividend yield, could be more earnings growth for longer than market participants expect, or valuation expansion.
To the extent that a strategy holds cash or fixed income, there can be returns from adjusting equity exposure or rebalancing. Cash has embedded optionality and gives the ability to re-allocate or increase allocation to equities on pullbacks, corrections, or bear markets. Rebalancing can contribute 100 – 200 bps to returns depending on market volatility and equity allocation. In balanced or diversified portfolios, drivers of fixed income returns are duration or interest rate sensitivity (as rates rise or fall, bond valuations fall or rise) and credit spreads. In non-government segments of the fixed income market, yield spreads relative to U.S. treasury bonds vary over time based on investors’ appetites for risk. Spreads can vary a lot based on the economic environment from tight levels at the peaks of business cycles to the wides at depths of recessions or the 2008 financial crisis.
Finally, culture and incentives of the team of people managing a strategy matter as much as process and philosophy. Low fees and expenses help an active manager outperform. They need to find good ideas with enough conviction to have significant active share relative to a benchmark. Often conviction in process is reflected in low portfolio turnover. Alignment of interests between shareholders in the fund or strategy and managers is crucial and can be established in a few ways. Having managers and analysts on a strategy personally invested in it is the most direct way. An explicit compensation framework that ties bonuses to individual and/or team contributions in a quantitative way over specific periods of time is another.
“Tell me how a person is paid, and I’ll tell you how he’ll behave.” - Bill Priest
Culture and incentives are especially important in investment firms because they operate in a constantly changing, increasingly competitive environment, like most professional services businesses. It’s not a business where the company can just make and sell what it has made for 50 years and expect everyone involved in production to complete the same repetitive tasks. A team needs to work well together, be adaptable, and be responsive to changes in the industry.
With adequate consideration of the above, an active manager can be successful and many have. While there are risks with successful implementation of proper process and philosophy by properly acculturated and incentivized people, there is a mirror image of risks with a mindless indexing process.
Carl Aschenbrenner is a portfolio manager at HCR Wealth Advisors , an SEC-registered investment advisor.
This article is provided for informational purposes only and should not be interpreted as investment advice. HCR Wealth Advisors is not affiliated with this website.
References
Cullen, James P., “Don’t Forget Risk.” Schafer Cullen Capital Management white paper, December 17, 2017.
Cullen, James P., “Mid-Year Outlook Look Out!” Schafer Cullen Capital Management white paper, June 15, 2020.
Dodge & Cox white paper, October 2016. “Understanding the Case for Active Management.”
Hartford funds white paper, 2020. “The Cyclical Nature of Active & Passive Investing.”
Meredith, Chris, “Value Is Dead, Long Live Value.” O’Shaughnessy Asset Management white paper, July 2019.
Priest, William W., Bleiberg, Steven D., Welhoelter, Michael A., and John Keefe. Winning at Active Management . Hoboken: John Wiley & Sons, Inc., 2016.
