Will fund managers cash in on a more favourable market backdrop?

Research suggests the market backdrop has become kinder to fund managers. Hannah Smith explains why and considers whether managers will take advantage.

It is about to get easier for active fund managers to outperform their benchmarks, according to research, but will they be able to take advantage of this more supportive market backdrop?

S&P Dow Jones Indices’ senior director of index investment strategy Anu Ganti has argued that the return distribution currently being seen in the S&P 500 index points to a better environment for active managers.

There was a shift last year in where returns were coming from – between the first quarter and third quarter of 2020, the largest companies outperformed, resulting in only 35% of shares outperforming the index. But, in the fourth quarter, the market reversed course, with a recovery of smaller company shares. At this point, 60% of stocks were able to outperform the index, almost double what was seen in the first three quarters of the year, giving stock-pickers a better chance of success.

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“The dominance of mega-caps hindered stock selection from the first quarter through to the third quarter,” says Ganti. “Meanwhile, in the fourth quarter, the comeback of smaller caps lowered the threshold for success, leading to a greater hit rate of outperforming the index.

“If the trends from the fourth quarter continue, we can anticipate a more favourable environment for active managers. Whether they will be able to take advantage of it remains to be seen.”

Cyclical sector recovery

Since the fourth quarter of 2020, the cyclical sectors, including banks, materials, energy, and consumer discretionary stocks have all rallied strongly on vaccine news, notes Kasim Zafar, chief global investment strategist at EQ Investors, a wealth manager. As a result, he argues there are not as many opportunities available now from a sector perspective. “The idea that cyclical sectors have a recovery still to go through is not true. The market has fully priced in the fact that we’re going back to some sense of normality,” he says.

However, he believes there is still opportunity to outperform from a market-cap perspective because of the diversity within small companies, which are not all cyclical stocks. Investors could access this theme either through a dedicated smaller company fund or a fund that invests across shares of all sizes, Zafar suggests.

Active managers have struggled to perform for many years, he agrees, but now “the opportunity for outperformance from managers that focus on value or drift down the market-cap scale is certainly better than it was previously”.

Large valuation dispersion

Garraway Capital Management’s multi-asset fund manager Mark Harris says it is hard to know whether active managers might now be able to beat the S&P 500 where they couldn’t before, as there are a few complicating factors. One is the large valuation dispersion that is still ongoing, and another is the difficulty analysts are having in accurately forecasting company earnings.

“There’s a lot of uncertainty about what companies are going to deliver, unless you’ve got a really stable stream of earnings,” he says. And, while value stocks look cheap relative to growth stocks, it is not clear whether they will be able to deliver earnings growth at the same pace in the long run.

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“If you’re a bit fleet of foot and you’re not wedded to only one way of looking at valuation, then there are huge opportunities to make gains. And obviously there are always going to be idiosyncratic stock winners that surprise, especially in periods of uncertainty. But beating the S&P 500, because it has got so many of the long-term winners, is going to be challenging.”

He says that, while there is always a chance that fund managers will outperform, it could just be that a lot of them do so because of “blindingly obvious opportunities”.

“If you are a good stock-picker and you can take a slightly longer-term view, or you can flex at the margin through these periods, I think you probably have lots of opportunities to add value. On the flip side, there are lots of opportunities where if you get it wrong you can have a tough time of it,” says Harris.

Opportunities for skilled active fund managers

There are other factors present in the wider environment that could hinder active manager outperformance for a little longer, although this could change, suggests Julian Page, head of fund research at DDQ Invest, an investment research firm. He points out that active managers generally have more opportunities to outperform when interest rates are higher and there are periods of lower overall returns across markets. Right now, we are in the opposite situation, he notes.

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“However, the huge spreads in valuations we see at the moment can create opportunities for skilled active managers. If the reversal in fortunes of small-cap and value stocks continues and fundamentals are viewed as being important again, we could see a greater proportion of active managers outperforming their benchmarks,” says Page. “The extent to which active managers would be able to capitalise will depend on their individual competencies and to a lesser extend the efficiency of the market in which they operate.”