After rough 2013, active managers might get a break

The past five years have been tough on active money managers, but some consultants and data analysts think 2014 could mark the end of that struggle.

With the average variance in returns among stocks — known as dispersion — in the S&P 500 at a 23-year low in 2013, according to research by S&P Dow Jones Indices, there wasn't a lot to separate the performance of good stocks and bad stocks. And therefore, there was not a lot to distinguish stock-picking managers who are worth the extra cash from those who are not.

“What we have found is that the potential for good managers to differentiate themselves from bad managers is deeply germane to the level of dispersion in the markets,” said Tim Edwards, London-based director of index investment strategy at S&P Dow Jones Indices.

Couple that low dispersion with strong performance in global markets, and it seems active managers had a difficult time outperforming in 2013.

As the new year gets underway, some managers and consultants believe a return to rockier markets will produce greater dispersion and more chances for good managers to shine.

“For 2014, while we don't have a crystal ball, it's hard to believe that (markets) will be as smooth sailing as 2013,” said Ian Shea, director, head of equities at consultant bfinance. “Amazingly, 2013 was a year in which the S&P 500 didn't have a correction greater than 5% — that was despite a number of potential hiccups.” The U.S. quantitative easing tapering discussions, a banking crisis in Cyprus and the U.S. federal government shutdown should have had more effect, he said.

“Volatility never really materialized and that may be hard to repeat in 2014. With increased volatility (stock pickers) tend to do better as there is a greater dispersion of returns.”

Investor behavior could also benefit active managers.

“We are now seeing, by and large, better economic news,” said John Walbaum, Glasgow, Scotland- and London-based partner and head of investment consulting at Hymans Robertson LLP. “We could now be in a scenario where investors are not just going to turn risk off at the first sign of bad news; with investors being discerning about the businesses they invest in, that is good for active managers. Against that backdrop, 2014 could well be a better year for active managers. It is always difficult to be successful in picking the winners, but perhaps the environment is more favorable now.”

Emerging markets stocks, which returned an underwhelming -2.4% within the MSCI Emerging Markets index in dollar terms, offer one area of opportunity for active managers.

“We are seeing quite a lot of dispersion there, and different drivers from a macro point of view in individual economies. There is a huge opportunity for active managers to outperform, but also to underperform,” said Ciaran Mulligan, global head of manager research at consultant Buck Global Investment Advisors in London.

Anticipated increases in interest rates are also a plus for active managers.

“Investors may become less concentrated on areas such as high yield,” said Richard Dell, London-based global head of consultant Mercer's equity boutique. “If that continues, I think there will potentially be an attractive environment for active equity investors.”

Other consultants think it will be more of a mixed year. “With lower dispersion, there is an expectation that, at some point, if recovery takes hold and things return to normal, macro drivers will fall away and company fundamentals will matter more,” said Stuart Gray, Reigate, England-based senior investment consultant, manager research at consultant Towers Watson & Co. “I am less convinced that a "normal' recovery is happening. I think there are still big issues to grapple with, such as U.S. tapering and other countries working out how to unwind quantitative easing they have put in place. Over the long run, I expect dispersion to go up, but I think it will ebb and flow. We could return to normal, but there is a risk of a policy error or government announcements that could shift markets to higher correlations.”

A more positive market environment is not the only good news for active managers; consultants say they are seeing clients warm to the approach.

“To an extent we have seen a shift in investors' mentality, too — some have been biding their time, understandably; when the environment doesn't look great for active managers, why would investors spend money on fees?” Mr. Walbaum said.

That trend played out in 2013. Institutional investors favored passively managed equity strategies over active, said a spokesman for eVestment LLC in Marietta, Ga. Passive strategies saw $30.4 billion of net inflows in the nine months to Sept. 30. On the other hand active equity strategies recorded $172 billion of net outflows in the nine-month period. However, passive strategies suffered in the third quarter of 2013, with $18.8 billion of net outflows.But some of the investors who stuck with their active allocations did benefit, as some managers bucked the 2013 trend and performed well despite the lack of dispersion.

“Many of the managers that we follow have outperformed (the MSCI World index), with some returning well in excess of that,” Buck's Mr. Mulligan said. He would not name any of the firms.

“But very few investors would look at performance only over one year to make a decision on active management,” he said. “If you look at the longer time frame, 2013 does stand out (in terms of lack of dispersion), but over the last seven or eight years dispersion has been there and good-quality asset managers have separated themselves from the pack and gone some way to justify the fees charged over a (passive) manager.”

A combination of unconstrained investment strategies, giving managers the chance to generate returns at “appropriate levels of risk,” and conviction-led investing helped a number of active managers to buck the low dispersion trend in 2013, said Terry Mellish, senior managing director at Natixis Global Asset Management in London.

Mercer's Mr. Dell agreed that some managers in Europe had a successful year. “Value-oriented managers that were exposed to cheap areas of Europe posted strong returns. But it depends which region you look at. There were issues for some global managers with exposure to emerging markets, which was a big drag on performance.”

Investor sentiment would also have hit dispersion, said Mr. Walbaum.

“There is no doubt that in recent years, not just 2013 but back to the credit crunch (2008), the risk-on/risk-off mentality that has been driving markets has made it very difficult for active managers. What tends to happen is correlations between stocks get very high and stocks all move in the same direction. Active managers are looking to find differentials between stocks based on the fundamentals of a business — if investors are simply buying or selling all equities indiscriminately, that is a difficult environment for active managers.”