Top heavy: A look at the performance of the MSCI USA index shows how the top 10 contributors, which account for less than 16% of its weighting, accounted for 33% of markets’ overall performance. Picture: REUTERS
Top heavy: A look at the performance of the MSCI USA index shows how the top 10 contributors, which account for less than 16% of its weighting, accounted for 33% of markets’ overall performance. Picture: REUTERS

Passive funds now account for more than 20% of global assets under management, a record high and more than four times what they were almost 15 years ago.

Stonehage Fleming, which provides family office services globally for wealthy families, believes this trend could partially reverse as market conditions change and become more favourable to active managers.

Active managers have historically performed better on a relative basis when intramarket correlations are lower, dispersion levels are higher and market leadership is not excessively concentrated. The first two points are true because they increase the managers’ opportunity set to generate alpha; if all stocks in their index are highly correlated, it negates the effects of taking active risk against the benchmark.

The point about concentration is a function of two things: it cuts the odds of generating alpha as it reduces the opportunity set of outperforming stocks; and it increases price momentum, which drives passive indices and makes them harder to outperform. The opportunity cost of not owning stocks that drive markets higher is greater when the concentration is higher.

One can look at the top 10 contributors to the performance of the MSCI USA index, which constitutes 777 companies, over the last three years. It shows how the top 10 contributors of an index, which account for just less than 16% of its weighting, accounted for 33% of the markets’ overall performance.

The fact that the top five stocks are all in the technology sector can also cause problems for active managers, which may have limits on exposure to any one sector for diversification reasons, or who may not have been comfortable either with the greater valuation, higher earnings, growth expectations or complexity of the underlying operating businesses.

A caveat is that increased concentration of market leadership in itself is not necessarily bad for active managers; the issue becomes more acute when the level of concentration is excessive and when the leadership becomes more persistent, as we have seen in the US.

An example of where active management has worked despite concentrated market leadership is European equities, where many managers have outperformed their passive benchmarks by investing in high-quality consumer and emerging market-focused companies and avoiding the large banks and energy companies. This persisted since the global financial crisis until more recently when the latter group has started to perform better.

We have observed that … dispersion levels have been increasing across all major equity markets

The reason for the appeal of larger firms in the years following the crisis had to do with increased investor appetite for higher liquidity, higher quality growth and balance sheets, and higher shareholder returns. The inception of quantitative easing programmes injected a mass of liquidity into markets, which is easier to deploy in higher versus lower market cap companies.

These years were characterised by instability in economic and political fundamentals, which drove investor preferences for higher quality companies with high and sustainable cash flows, as well as solid balance sheets. These qualities tend to be more prevalent in larger, mature companies rather than faster growing but higher risk smaller ones. Economic fundamentals have stabilised, which has seen investor focus shift from more defensive stocks towards large technology companies with higher growth and momentum characteristics.

Finally, the low interest rate and bond yield environment internationally has led to an increased focus on shareholder returns from equity. This has led to investors favouring companies with higher dividend yields or those that have initiated large share buy-back programmes, which again is more typical of larger companies which generate enough cash or have enough collateral to borrow to cover these activities.

One of the key drivers of an active manager’s relative performance and active risk is not only the stocks held within their index benchmark but also what is not. Active managers as a group have a structural bias towards holding smaller companies relative to a benchmark because these companies are typically less well researched (so have a higher probability of being mispriced), can have higher growth rates relative to their more mature larger company counterparts, and can have a greater interaction with management given their relatively higher level of ownership.

The dynamics of this overweight to smaller companies varies; in the US smaller companies generally exhibit greater beta than larger counterparts and tend to do better as a group when markets are rallying, while in Europe and emerging markets the dearth of liquidity in many of these stocks means their relative performance is more idiosyncratic in nature.

An example of when active managers have enjoyed a more conducive environment of less concentrated market leadership and better performance of smaller companies was from 2004 to 2006, when the markets came out of the technology boom and bust of the late 1990s. During this period, the median global equity manager outperformed the MSCI world index.

Why do we believe there are signs that the fortunes of the active management industry are likely to see an uptick?

We have observed that intramarket correlations have been declining and dispersion levels have been increasing across all major equity markets. This has coincided with investors focusing on company earnings and the fundamental economic backdrop rather than macro news flow, although volatility from the latter cannot be discounted.

• Torr is a senior associate with Stonehage Fleming SA.

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