- Investment Specialist
United Kingdom, Institutional
Change
The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Equity Market Outlook section.
As equity allocators investing with an eye toward factor-based risks, we saw some active managers struggle in 2022 as the market rotated to a narrower set of beneficiaries amid immense shifts in commodity prices, economic conditions, government policy, and interest-rate expectations. It is not surprising to find that stock selection is challenged when the macro environment leads to less differentiation and a narrow cohort of winners. Instead of seeing strong fundamentals rewarded in value, growth, and quality, for example, we witnessed factor rotation in the tails — i.e., across deep value (related to rising rates), speculative growth (related to the economic slowdown), and lowest beta (related to war and commodity shocks). Over the longer term, we believe fundamentals eventually win, but our research on the factor performance of the past couple of years suggests some important takeaways for allocators:
- Consider defensive allocations to complement growth and value — If we are in a new regime of volatile, directionless markets, that is not necessarily good or bad for active stock picking/results. But it may mean that dedicated defensive allocations are needed as the risk profiles of growth and value allocations change more frequently and more violently, making it challenging to balance risk through the cycle (we are seeing this already).
- Seek areas with increased opportunity for stock pickers — With the interest rate/inflation environment changing, some of the dynamics in growth (persistence) and value (quality differentiation) may evolve or revert to their pre-GFC (or even pre-dot com) patterns: more volatility/less sustainability in margins, more focus on balance sheets, more opportunity for stock picking across the market-cap spectrum, and more opportunities for mean reversion. We would expect this to benefit fundamental bottom-up research and support active allocations to small-cap/mid-cap segments, value, and equity income.
- Consider the time-horizon mismatch when evaluating stock-picking skill — At times, stock picking suffers when managers are focused on their company investments with a longer-term view based on fundamental execution and not directly based on current macro sentiment. This mismatch of time horizons is the key challenge in our manager research process and is even more pronounced when the market is hypersensitive to short-term macro drivers as it has been recently. Ultimately though, we are willing to live with stock-selection challenges for a reasonable period if a manager’s portfolio behaves as we would expect and there is a robust, resourced, and repeatable process underpinning stock selection.
- Look for diversifying strategies — Taking into account the typical headwinds to active management, allocations to large-cap value, equity income, and low-beta strategies may be diversifying if we get a regime shift away from growth, momentum, and high quality.
- Increase the use of macro stress tests — We believe we will see more differentiation in economic cycles and macro policy globally in the next 10 years versus the previous 10. A suite of macro stress tests can be an important tool for determining whether shorter-term macro moves that are exogenous to an allocator’s process have the potential to impair the ability to meet long-term risk/return objectives.
- Evaluate managers with the active-management conundrum in mind — If active managers try to manage index concentration by matching benchmark weights to big names, they run the risk of being labeled a benchmark hugger as their active share plummets. All else being equal, we find active managers tend to be significantly overweight more “higher upside” stocks rather than use the same capital to be only moderately overweight one megacap stock. We believe this bias can generate more alpha in the long run but also causes more cyclicality in active results. The key is how a manager balances this trade-off — an important consideration in the evaluation of active manager allocations, which we wrote about in this recent note.
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- Co-Head of Investment Strategy
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