For two decades in a row money has money has flowed out of active funds. Last year, 100 billion euro suddenly flowed into active funds. It was the best year since 2000.
Active managers naturally tend to emphasise value and size factors. As a group, they prefer relatively small companies that are cheap. The problem for these active managers, however, has been that the past decade has actually been exceptionally good for the larger and more expensive companies in the index.
Coincidentally, these are also the companies that are strongly represented in the index and so they are also the stocks that have benefited most from the flow of money into index funds.
Passive or active?
There is a long-term cycle in the relative performance of active and passive funds. That cycle depends on market conditions.
Active managers who seek out the best companies only perform well if they are actually rewarded for this selective behaviour. When the market is dominated by macroeconomic or monetary developments, many shares move in the same direction at the same time.
The Risk-on/Risk-off market during the first years of quantitative easing is well known. As soon as the central bank opened the money tap, all shares profited. As soon as this extra liquidity dried up, it was just as risk-off. On balance, the liquidity kept flowing and this resulted in a strong bull market in mainly US equities.
Private equity feared
Moreover, monetary policy ensured unprecedentedly low interest rates and, especially in the United States, companies bought their own shares en masse with money they had borrowed on the capital market. Less equity and more cheap borrowed capital, thanks to the leverage, resulted in a much higher return on that equity and such companies were given a higher valuation.
It was precisely in the United States that this phenomenon occurred; year after year, American companies were the biggest buyers on the stock market. On the one hand, this was due to the unfavourable tax treatment of paying dividends versus buying back shares.
On the other hand, many CEOs and CFOs felt private equity breathing down their necks. If they did not optimise the company’s balance sheet, there was always a private equity sponsor willing to do it.
Better market for active investors
Now the end of the era of free money is fast approaching. The number of bonds with negative interest rates has not been this low for a long time. The search for yield seems to have come to a definitive end and with it the flow of money towards passive investments.
This flow of money resulted in a high correlation between equities and relatively low yield differences (dispersion). This year, this is improving. The correlation is decreasing and the dispersion is increasing.
There is also more volatility. The financial world often defines volatility as risk, but for the stock picker, volatility is a source of alpha.
This volatility also provided a nice litmus test in January. Active investors often confuse taking extra risk with generating alpha. Yet nine times out of ten, the outperformance of an active manager is simply due to taking extra risk.
Stars no longer shine
In January, therefore, several ‘Star Managers’ of recent years collapsed. After showing returns of 30 to 40 percent or more last year, many went down in January by 20 percent or more. This is devastating for the composite return.
So, is 2022 not the year of the stock picker after all? It is.
Here too, appearances are deceptive; only a few growth-oriented managers actually became momentum investors after years of outperformance. Outside the growth segment, active managers quickly outperformed the index, with 69 percent of value stocks outperforming the index and as many as 81 percent of small caps.
On balance, more than half of active managers outperformed the market. That does not happen often.
Beating the index
The advantage for stock pickers is that the index now resembles a bizarre barbell strategy, with Big-Tech companies on one side and zombie companies on the other. Although they are each other’s opposite numbers, both groups of companies are suffering from rising interest rates. In the case of growth companies because a higher discount factor is only possible with a lower valuation, and in the case of zombie companies because they have a lot of debt, which suddenly becomes unaffordable with rising interest rates.
For stock pickers, it is not only about selecting the winners, but also about identifying the losers. It is precisely in times of disruptive innovation that there are many losers.
Furthermore, inflows into active funds are helping to beat passive index funds. The big rotation out of bonds into equities has only just started. Now active managers suddenly have momentum.
Han Dieperink is Chief Investment Strategist at Auréus Asset Management. His column on Investment Officer Luxembourg appears every Thursday. Dieperink provides his analysis and commentary on economics and markets. Earlier in his career he was Chief Investment Officer of Rabobank and Schretlen & Co.