Views

Manager Selection In A Low Growth Environment (Value Creators)

12th July 2017

The last ten years have seen strong market returns driven to QE-fuelled highs. As monetary accommodation is reigned in, manager selection is going to become more important than ever.

We believe that developed economies will remain in a low growth environment for the next decade or longer, albeit with moves around the average. This is the result of several long-term macroeconomic headwinds – from the global deleveraging cycle, to ageing populations, and globalisation and technology suppressing wage growth.

At the same time prices across most major asset classes are elevated and bond yields remain near historic low levels. The chart shows how equity market valuations are at levels (the red diamond) far above even the top of historical ranges across the major equity regions.

Forward valuations graph
 

The combination of low growth and elevated asset prices creates a perilous environment for institutional investors. As such what worked over the past decade is unlikely to work over the coming decade. 

Active versus passive debate

The landscape is becoming increasingly scrutinised in the selection of fund managers, with active management rightfully under attack in the media, and the FCA questioning advisers’ selection capabilities. However, broader debates about passive versus active investing tend to be misguided. Whilst using passive funds to gain low-cost exposure to certain markets may be sensible, investing entirely in passive strategies has its limitations, namely:

  • We expect low returns for most assets classes in the coming years and as such passive strategies are unlikely to achieve most return targets;
  • Most passive indices will experience high correlation, especially in time of distress, thereby limiting the ability to benefit from diversification.

For us the question should not be “passive versus active”, but “where within active” can one generate outsized risk-adjusted returns, and we have defined a narrow universe of managers where we believe this is possible.

We start by examining the source of “alpha” from active managers across all asset classes. The vast majority of managers generate alpha in a traditional way – through stock selection and/or portfolio construction.  We have dubbed these managers “value identifiers.” These are the fund managers who will buy an asset because they believe it is undervalued, in the expectation that the market will catch up and reward their view. In a low return environment, driven by central bank liquidity and government spending, these managers will struggle.

However, a very small proportion of active managers generate alpha not only by identifying value but also by creating it. Whether they are investing in equities, credit, private equity or real estate, these managers “roll up their sleeves” and are more actively engaged with each investment. 

These “value creation” strategies could include, for example, shareholder activists taking seats on a company board, distressed credit managers leading bankruptcy processes, private equity managers pursuing a consolidation strategy, or real estate managers repurposing properties.

We believe in this environment of low growth and elevated asset prices, it is the fund managers who take the more “hands-on” approach who will be best positioned to achieve outperformance. These managers may be hard to find but we believe the rewards are worth it.