Last updated: 13:45 / Wednesday, 9 December 2015
Build on Insight, by BlackRock

Has Volatility Fueled Active Management?

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Has Volatility Fueled Active Management?
  • There is a high probability the Fed will raise interest rates this month
  • In order to maintain the same level of returns, investors will have to change their strategies

During the last six years, US equities experienced a nearly uninterrupted rally. An unusually accommodative monetary policy environment coupled with economic and earnings growth helped fueled the U.S. stock market—things, however, are starting to change.

The Federal Reserve (Fed) is signaling its intention to normalize monetary policy, which could happen as early as this month. At the same time, earnings growth outside of energy is modest and valuations are on the expensive side of fair value. It is therefore likely that investors going forward will not only have to adjust to more modest returns from U.S. stocks, but they may also have to brace for heightened volatility at a time when U.S. fixed income will continue to yield low level of returns.


 
In order to maintain the same level of returns, investors will have to change their strategies. One way to do so in the equity market would be to look for beta by pursuing cheaper markets (sectors, factors, geographies) with fundamental tailwinds, as well as strategies that have long-term structural support. For example, exposure in Europe or Japan—other developed countries with improving economic activity, accommodative monetary policy, cheaper currencies and strong profit growth.

Another strategy would be to combine active and passive management. While passive management has outperformed active management in the last years, this was done at a time during which the stock market was moving higher and was immersed in a low volatility environment, where generating alpha proves to be more difficult. Nowadays, investors can potentially benefit more from security and risk selection, be it via actively-managed exchange traded funds (ETFs), multi-asset managers, long/short managers or traditional active equity managers. However they must keep in mind two essential issues with active management:
•    Finding a top-tier investment manager who will benefit from this shift in the investment environment is not certain, and
•    Alpha generation is basically a zero-sum game over time. In aggregate, investors compete to generate alpha, creating winners and losers.

Although the dataset is admittedly small, historical data shows that in US large caps, periods when alpha generation improves happen to coincide with periods of stress in financial markets. So, while alpha generation may be thought of as sourcing opportunities to generate a higher return, it may equally be thought of as being underweight risks during times of heightened financial and economic stress. Thus, it might be safer to have a more thoughtful approach to combining alpha and beta strategies going forward.

In regards to the fixed income sphere, (where given the low level of interest rates it doesn’t take much of a reversal in interest rates to wipe out a year’s worth of coupon income), in order to boost returns and generate sufficient income, investors may feel compelled to migrate to ever riskier credits, extend maturity/duration, or allocate to less liquid securities. However, like with equities, there is an option other than pure market beta. Instead of taking more risk, investors could consider how they build alpha generation tools into their fixed income portfolio.  One way to do so would be employing global multi-asset income solutions as a way to limit volatility while also pursuing objectives like income and total return. Tools such as unconstrained bond funds, global long/short credit or credit ETFs can be a good way of diversifying your fixed income sources.

With the world 'normalizing' comes the worry of higher volatility. Yet, it also presents an opportunity for alpha generation that has somewhat evaded markets in recent years. Investors can take advantage of that through picking the right active fund manager, through flexible multi-asset portfolios while also employing beta strategies to boost returns through tactical sector, geography and factor tilts.


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This material is for educational purposes only and does not constitute investment advice nor an offer or solicitation to sell or a solicitation of an offer to buy any shares of any Fund (nor shall any such shares be offered or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator in any Latin American and Iberian country and thus might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein.
 

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