Global equity allocations in active management strategies will likely outperform passive management as global markets remain volatile and the risk of a market shock looks high.
This is the view of Paul Hennessy, head of the US$1.6 trillion Capital Group’s Australian business and Matt Reynolds, Capital Group’s local Investment Director. They believe that a handful of active managers which offer funds that consistently outperform benchmarks are starting to get traction.
While most active managers struggled to beat the index in the roaring bull market that followed the financial crisis, there are some active global equity managers that have consistently outperformed their passive rivals. As Paul Hennessy acknowledges, the skill is in knowing just who those fund managers are.
“While investors have just experienced one of the most spectacular periods of returns in recent history, history tells us that stock market declines are an inevitable part of investing,” says Hennessy.
The country head of Capital Group called it a myth that passive funds provide a low cost easy means to access markets without taking much risk. “The passive world has done a great job of making people think their products are lower risk,” he says.
“The problem is markets don’t go up in a straight line – the downside of enforced momentum trading is likely to be proportionally greater when disaster strikes. And the concern for passive investment products is that they are guaranteed to get 100 per cent of a down market.”
Capital Group’s flagship global equity fund in Australia – the New Perspective Fund (NPF) – has delivered, on average, after-fee returns of more than 13 per cent per annum in Australian dollar terms for more than 46 years. Moreover, it has achieved an excess after-fee return of 3.5 per cent over its benchmark the MSCI All-Country World Index.
That makes Hennessy a total believer in active management but warns that the ability of a manager to consistently meet stated returns will be key. Capital Group’s recently appointed Australian Investment Director, Matt Reynolds is convinced that bottom up, active managers have a greater opportunity to outperform the broader markets in volatile times because they make individual choices on a company by-company basis.
“In contrast, if you buy the index, you get a slice of every single company in the index whether that company is good or bad, well-capitalised or not, whether it has decent product or not and whether it is overvalued or not,” he said.
Worse, he argues, passive strategies can lead to irrational investor behaviour such as buying stock at the peak of its share price cycle. Or, having a big part of a portfolio concentrated in a single region, or sector, or a particular sector because the index happens to be structured that way.
More volatility ahead
Hennessy and Reynolds like to point to the resilience of Capital Group’s flagship New Perspective Fund when markets have dropped significantly. On a rolling three-year basis, on the 80 occasions since March 1973 that the MSCI All-Country World Index has experienced a downturn, NPF has outpaced the market 100 per cent of that time.
Capital Group is expecting more uncertainty over 2019 and 2020 as the world’s investors continue to grapple with the dual fears of market volatility and rising geopolitical risk. Trade wars, Brexit and a flattening yield curve are all taking their toll on markets.
Add into the mix, the European parliamentary elections, the departure of Mario Draghi from the European Central Bank and the sudden decision by the US Federal Reserve to hold interest rates steady.
Reynolds says, “While this is very good for equity prices which rose with the reversal in the stance of raising rates, it creates some concern as to how the Fed behaves during the rest of the year.”
JANA Investment Advisers CIO Steven Carew says the recent rise in market volatility, divergence in valuations in a number of sectors and regions, and greater idiosyncratic risks – including differential impacts from changes in trade policy and currency movements – should be a more conducive setting for active investment strategies.
Carew concedes that while the narrow and sudden changes in market leadership have made the past few years very difficult for active management, JANA retains confidence in the ability of active management to deliver outperformance and manage risk.
The asset consultant concludes that in a low return world, any incremental value that can be produced from asset selection and risk management is highly valuable.
Following high convictions while limiting risk is a key plank of Capital Group’s investment strategy, according to Matt Reynolds. To him everything about Capital Group’s multiple-portfolio-manager system limits the risks associated with isolated decision making. “The idea is to have multiple perspectives to limit the risk of people making the wrong decision at the wrong time.” He says that the key to active investment – the absolute bedrock of this investment strategy – is diverse approaches.
Multiple portfolio managers
As they see it, the power of Capital Group’s investment approach – what they call the Capital System – lies in the fact that the total portfolio is made up of a number of high-conviction ”sleeves”, managed by individual portfolio managers, that are combined to create a total portfolio that helps to dampen the volatility of investment results.
The Capital System is unique, they go on to say, in that each portfolio manager has a high level of conviction and expected return but they pick up the diversification element of having a number of portfolio managers contributing to the portfolio.
At the same time, the fund emphasises individual responsibility within pre-set boundaries – no-one tells anyone else what they can or cannot do.
Within a strategy, some managers may take a balanced view with regard to risk when managing their own share of assets. Other managers may have more concentrated portfolios containing greater risk than a single, ‘star’ manager could if he worked alone, and was therefore responsible for all of the portfolio risk.
“There is no point including a portfolio manager who has exactly the same investment approach as another portfolio manager”, explains Reynolds.
This style is in stark contrast to the vast majority of active managers that have a lead portfolio manager supported by a team of analysts. “This can lead to tremendous disappointment if the portfolio manager’s view of the world doesn’t turn out to be correct.”
The New Perspective Fund has seven portfolio managers based in all the major investment jurisdictions around the world, all with differentiated world views.
“We put them together and create the opportunity for them to achieve the best returns they can possibly achieve for their portion of the portfolio. Thus, the portfolio as a whole picks up the diversification of any one person being wrong at any one point of time.”
Naturally, he says, controls are in place to prevent inappropriate concentrations of risk – at the security level and in aggregate.
“We think it makes our results robust and helps to ensure that the fund doesn’t see prolonged periods of underperformance. So we produce a more consistent return outcome than many other single portfolio manager funds.”
Copycat rivals
The big question is why rivals haven’t tried to emulate the model given the outcomes are so compelling. The Capital Group executives don’t have an answer except to say that the Group’s longevity sets the global asset manager apart from competitors.
They accept there are some asset managers with a long pedigree, but it is unusual to have one – like Capital Group– that is culturally and philosophically the same company as it was when it began in 1931.
They also say it would be hard to replicate the portfolio management team since analysts gain experience of managing assets in client portfolios for up to a decade before they become fully fledged portfolio managers.
A key driver of the New Perspective Fund’s long-term results is the eligibility criteria – which has not changed since 1973 when the fund was created to exploit changes in global trade patterns.
“Many of our funds are designed to outperform their broader markets over a very long time and the type of companies we buy for the funds are extremely important to generating that outperformance.
This jibes with Sarkis Tepeli, a principal consultant with Frontier Advisors, who says regular monitoring of active managers and why they outperform is especially important to determine if an investment manager is losing its edge and ultimately its alpha generation capability.
The consultant also stresses the importance of manager selection with active investing as well as the importance of building out a balanced equities configuration with sufficient exposure across the market cap spectrum, geography and manager style/factors.
Tepeli has another reason for veering towards active investing. He says investing with a focus on favours active management for environmental, social and governance (ESG) favours active management.
He reckons fundamental active managers are best placed to assess ESG considerations for each stock on a backward and forward looking basis.
“Although indexed passive managers have been building up their engagement capability, we feel their efforts are still lagging those of the better fundamental managers,” he adds.
