In part two of this two-part mini-series, Nick Watson, portfolio manager with Janus Henderson’s UK-based Multi-Asset Team, discusses why alpha-generating managers are likely to be in ever greater demand, and focuses on dynamics within fixed income. As an allocator to both active funds and passive instruments, he argues it is crucial to consider questions of ‘where’ and ‘when’ when making decisions.
The importance of alpha
‘Buying the market when it is cheap generates great returns over the next decade’ is an often-cited maxim for the long-term investor. We would caution that buying at expensive valuations presents a far less rosy return outlook. This is particularly important when expectations are for lower returns and increased volatility, which we believe we are now approaching, as outlined in part one of this series. Based on cyclically adjusted price-to-earnings (PE) ratios dating back to the late 1960s, analysts would expect an annualised return of roughly 6-8% a year over the next decade from the S&P 500 (chart 1). Examining data for other regional equity markets, valuations range from looking fair value to expensive. The key takeaway is that nothing appears cheap. Thus, the starting point for current markets is that it doesn’t look a particularly attractive entry point from a pure passive/beta point of view.
Chart 1: US PE data suggests returns will be more muted
Source: Bloomberg, data as at 31 January 2018 (data starts in 1969), cyclically adjusted PE ratios for the S&P 500 and 10-year forward returns. Red bar shows current S&P cyclically adjusted PE. Past performance is not a guide to future performance. US market is used for illustrative purposes and does not constitute investment advice. Past performance is not a guide to future performance.
In the world of muted returns and higher volatility that we anticipate going forward, the proportion of client outcomes that could be delivered by active alpha strategies becomes increasingly important. When the market returns +20% a year, the potential alpha of roughly +2% is broadly irrelevant as beta dominates. The vast majority of returns come from beta and just holding the market. However, when markets are more muted and return +2% a year, that additional +2% alpha from the active portfolio manager suddenly doubles the return experience. The challenge comes in identifying an active manager, or blend of active managers with complementary styles, to deliver that +2% alpha.
Chart 2: Alpha becomes more important amid lower returns
Source: Janus Henderson Investors as at 28 February 2018. Chart is for illustrative purposes only and does not constitute investment advice.
That said, it is of course not a case of backing just any active stock picker; it is essential to find the right stock picker for the particular market and the approaching stage in the cycle. As market returns weaken and the contribution of alpha becomes more valuable, the benefits of identifying the right active fund should become increasingly visible.
Unfortunately, this change of tone in markets and return expectations does not present a great environment for investors in absolute terms. But we view it as a great time for genuine alpha generators, both in terms of stock picking active managers and fund selectors, as their contribution grows in importance. We just need to strive to make the right choices.
Fixed income in focus
Firstly, one of the major calls in any client’s fixed income exposure is the level of interest rate duration (interest rate sensitivity). For us, the most straightforward approach to managing this is through government bond futures, which can be used by an active asset allocator to identify exactly which location on the bond yield curve should be targeted and how much interest rate sensitivity they want to take.
Our decision on how much duration and the role it plays in our portfolios is often the key factor of our asset allocation decision, rather than the marginal alpha an active government bond strategy might be able to produce. So, in the case of our Multi-Asset portfolios, where permitted, we utilise sophisticated and incredibly liquid instruments to accurately implement our market/beta views on interest rate duration without the complications of active managers and fees.
Elsewhere within fixed income, the passive versus active debate has a much stronger contribution to make, particularly in those areas that enable active managers to navigate the entire fixed income universe or in those bond asset classes that demand a more bottom-up approach. These parts of the bond market, such as high yield and emerging market debt, also present challenges for the efficient implementation of passive vehicles.
A cautionary note on ETFs
Within equities, the passive replication of an equity index with a small management fee provides very efficient exposure to the wider market; the overall return experience of a passive equity instrument is very close to that of the reference index.
We would say that these dynamics are not the same when approaching passive versus active in fixed income. Let’s take the US high yield market as an example. This asset class has become increasingly popular over the past decade as investors starved of yield have migrated into higher risk and higher yielding assets. The nature of the asset class and the considerable fee burden charged by exchange-traded funds (ETFs) means that the passive options available to investors have materially underperformed the index.
We would therefore argue that the benchmark for an active fixed income manager is not the wider index, as that is not available to buy. Instead, we think the active manager should be evaluated against a suitable ETF, as that is the only possible investment option for an investor who doesn’t wish to pursue an active strategy.
Chart 3: A wide performance gap in US high yield
Source: Morningstar Direct, monthly data net of fees in US dollar terms, as at 28 February 2018. SPDR Bloomberg Barclays US high yield ETF, Bloomberg Barclays Very Liquid Index (VLI) High Yield, US high yield sector average. Data rebased as at 30 November 2007. Past performance is not a guide to future performance. The US high yield market is used here for illustrative purposes and its use does not constitute investment advice.
To us, using this framework of evaluating active managers against their passive competitors is relevant, because it demonstrates the real choice open to an investor. It also shows the value that can be added by active managers in this part of the fixed income market, above that generated by the purchase of the ETF.
Fixed income – big winners, big losers
The outcomes delivered by the average active manager in the US high yield market demonstrate a positive picture of added value from high yield stock picking. This is not, however, a picture of consistent alpha generation, which reflects our observation of there being a time and a place for active.
Active managers historically have tended to underperform their passive competitors when the high yield market has a sharp rally, which is reflected by rising prices and plummeting yields. In such a rally, the biggest winners are most likely to be most highly levered, economically sensitive companies; those high yield bond issuers at most risk of default. It is no surprise that active managers are going to avoid such credits as the yield on offer is unlikely to suitably compensate an investor for the higher risk of a default.
By contrast, in a more stable environment of gradually declining yields and modest levels of capital growth, active managers have historically held their own and performed in line with their passive competitors. In this instance the fundamental research conducted by high yield analysts, which tilts towards higher quality companies with less distressed business models and lower likelihoods of default, has kept up with the returns delivered by the wider index with its generally higher risk of default.
Rising yields, rising alpha?
Where active funds really come into their own is in a rising yield environment (chart 4). In a softer period for markets or in an economic downturn the most distressed companies get hurt the most, and it is these companies that an active credit picker would choose to avoid.
Chart 4: long-term active alpha during a rising yield environment
Source: Morningstar Direct, as at 28 February 2018. Yield and alpha data, monthly since 30 November 2007. SPDR Bloomberg Barclays US high yield ETF, Bloomberg Barclays Very Liquid Index (VLI) High Yield, US high yield sector average. Performance net of fees in US dollar terms. Dashed lines indicate potential direction of travel (source: Multi-Asset Team). PM = portfolio manager. Past performance is not a guide to future performance. The US high yield market is used here for illustrative purposes and its use does not constitute investment advice.
Given the starting point of investor crowding in passive high yield vehicles, vast inflows into the asset class over the past five years, low yields, low default rates and distressed corporate structures bailed out by historically low interest rates, we find it very hard to make a bullish case for yields to decline further from these levels. This is emphasised further by the maturing nature of the US economic cycle, the end of QE, and the uptick in expectations for interest rate rises.
For us, a best case scenario would be that bonds trade sideways from here and investors clip the coupon from their bonds as yields stay stable. In this type of environment, looking at historical data, the average active manager has performed in line with their ETF competitors net of fees.
In a less benign outcome of gradually rising (or potentially sharply rising yields), active managers aim to protect their clients from the worst of the ensuing sell-off and generate alpha.
So, we would therefore conclude, that allocating away from passive high yield into an active manager at this stage in the cycle presents the investor with optionality – similar returns if the status quo persists, but the likelihood of protecting capital if the backdrop deteriorates. Such an asymmetric payoff in favour of the active bond manager sounds like a sensible use of client capital to us. It also further strengthens the argument for having a clear view on ones macro outlook and being highly selective in ‘where’ and ‘when’ to use active or passive vehicles.
Alpha = alpha is the difference between a portfolio's return and its benchmark’s return after adjusting for the level of risk taken. A positive alpha suggests that a portfolio has delivered a superior return given the risk taken.
Beta = a measure of systematic risk. A beta below 1 can indicate an investment with lower volatility than the market, a beta above 1 can indicate an investment with higher volatility than the market.
Yield to worst (YTW) = the lowest potential yield that can be received on a bond without the issuer actually defaulting. The YTW is calculated by making worst-case scenario assumptions on the issue.
These are the views of the manager at the time of writing in March 2018. They may differ from the views of others at Janus Henderson Investors. Sectors, indices and funds mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell any of them.