The last few years have not been kind to stock pickers and active management in general. From long-only, benchmark-driven funds to hedged equity strategies, beta has been the operative keyword in driving performance. One only has to look at the flow of funds into passive index vehicles to see what the allocator community thinks. But, as Bob Dylan once sang, “The times they are a-changin’.”
It’s no secret that the Fed’s accommodative stance since the end of the financial crisis has proven to be a windfall for the equity markets. For the five years ending December 31, 2015, the S&P 500 has annualized 12.5%, a bull market by name if there ever was one. The resulting low cost of capital has provided a boon to many companies. Simply look at the M&A market to see how all this capital is being put to use, with new high watermarks being set every year in buyout and merger activity. And while investors have enjoyed the benefits of this bull market, the same can’t necessarily be said for the fundamental equity research camp. The benign rate environment, while good for corporate America, has proven to be frustrating for active managers.
Nomura Securities (by way of Barron’s) provides an interesting analysis in looking at the outperformance of active managers vs. interest rates. There appears to be a strong correlation between interest rates and the ability for active managers to outperform their respective benchmarks:
In lower rate environments, managers have struggled to provide excess returns, while in rising rate environments, the opposite is true. There are a number of factors to consider as to why this occurs. Most notable is the fact that cheap credit lessens the differential between good and bad companies as balance sheets get distorted. Price correlations, between sectors as well as stocks, rise significantly as the market becomes indiscriminate as to its purchase rationale. Company-specific characteristics are overlooked in favor of macro trends resulting from a world awash in liquidity. This, in turn, lowers market volatility and, unfortunately for fundamental analysis, lowers the opportunity set for price anomalies — a necessary ingredient for active management. The alpha opening narrows significantly.
Conversely, when interest rates rise, the proverbial tide goes out, pushing up volatility, valuation dispersion and mispricings, exposing idiosyncratic risk in stocks. Fundamentals begin to matter again. The playing field in this new dynamic changes a bit with the return of “information competition,” as managers must now again square off with each other instead of just Mr. Market. Competitive advantages will go to those managers who capitalize on the tools and processes to establish an “information edge” — exploiting the dislocations set up in today’s market.
The return of a rising interest rate environment and subsequent opportunities to add alpha means good fundamental analysis will be more important than ever. Higher volatility, mispricings and valuation anomalies will be available for the taking. However, it will be those managers who have the right toolset to best identify, validate and act on these information discrepancies that will win the new active management game.
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