Active Management: Don’t Drop the Pilot

For years, we’ve advised clients to hold diversified portfolios with balanced allocations to stocks, bonds and other assets. Lately, it’s been a hard sell, especially after years of underperformance by active equity managers. But the tide may be turning.

We understand why clients are skeptical:

  • Firstly, equities have underperformed bonds and actively managed equities have struggled to beat passively managed equities. Investors tend to sell what’s done badly and buy what’s done well. And in recent years, hundreds of billions of dollars have moved out of active equities into passive equities and bonds.
  • Secondly, changes in accounting rules and regulations have raised the cost of holding equities, causing investors to reduce their allocations.
  • Thirdly, the quantity and speed of information keeps accelerating. A decade ago, an investor would have to wait a few days after month end to see their performance. Now they can get an update every day and even every minute. Psychologists have shown that people tend to manage what they can measure, so as measurement has got quicker, investors’ focus has become increasingly short term.
Which of these factors might be cyclical and which are more likely to stay? I think performance is cyclical, as it tends to be mean-reverting: bad performance is often followed by good and vice versa. So the fact that equities have underperformed bonds for the last 10 years increases the likelihood that equities will outperform bonds over the next decade. The same can be said for many active managers’ strategies after several years of underperformance.

Moreover, I think that a swing in the cycle could be imminent. Our models, which rely on a huge range of past experience and likely future linkages between economic and financial factors, suggest that equities are very attractive. Whether you look at the so-called equity-risk premium—the extra returns offered by shares over “risk-free” investments like government bonds—or the price-to-book ratio—a measure of value—equities look cheap. Similarly, with yields at historic lows, bonds look expensive (bar some specialist areas such as high yield). All this, we believe, augurs well for sentiment to swing back in favor of active managers in the near future.

Of course, some factors on my list are likely to be permanent, such as changes in accounting rules and regulations. And given technological developments, it’s highly likely that we’ll be getting more information at faster speeds, for better or worse.

Against this backdrop, active managers are trying to help clients deal with risk as well as return. For example, they’re offering “insurance” to protect portfolios from tail risks, such as many equity investors suffered in 2008-2009, by using derivatives or counterbalancing portfolios. Active managers are also constructing portfolios to protect against inflation risk—when conventional bonds tend to suffer—by including assets such as commodities, index-linked bonds and equities. And in their search for good risk-adjusted returns, active managers are exploring new territory like emerging markets, and mastering new techniques, like asset allocation, as multi-asset or diversified growth funds come into vogue.

So while it’s been a tough decade for active equity managers, we think the tide is turning. There are plenty of signs suggesting that now is not the time to give up on either equities or those charged with piloting them.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams. 

Patrick Rudden, CFA

Portfolio Co-Manager—Dynamic Diversified Portfolio and International Head—Multi-Asset Solutions
Patrick Rudden was appointed International Head of Multi-Asset Solutions in 2013 and is Co-Manager of the Dynamic Diversified Portfolio. From 2009 until 2013, he was head of Blend Strategies. Rudden joined the firm in 2001 as a senior portfolio manager for Value Equities. He has published numerous articles and research papers, including, “What It Means to Be a Value Investor”; “An Integrated Approach to Asset Allocation” (with Seth Masters); and “Taking the Risk Out of Defined Benefit Pension Plans: The Lure of LDI” (with Drew Demakis). Previously, Rudden was a managing director and head of global equity research at BARRA RogersCasey, an investment consulting firm. He holds an MA in English from Oxford University and an MBA from Cornell University. Rudden is a CFA charterholder. Location: London

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