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Active managers struggle to prove their worth in a turbulent year

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The history of financial markets has more wild plot twists, temper tantrums and triumphant comebacks than a daytime soap opera — or a US presidential election for that matter. Even by Wall Street’s standards, 2020 has been exceptional, yet for some active asset managers it offered the promise of salvation of sorts.

Over the past two decades there has been an epochal shift of power from the pedigreed stockpickers and bond kings who have straddled markets, to the cheap, passively-managed index funds now in the ascendancy.

In the past 10 years, passive equity funds have enjoyed inflows of more than $2tn, even as traditional, active ones have suffered outflows of over $1.5tn, according to data provider EPFR. There is now over $12tn in index funds globally — either passive mutual funds or the increasingly popular exchange traded funds — according to Morningstar.

This underestimates the heft of passive investing, as many big pension plans and sovereign wealth funds now manage index-tracking strategies internally. “In many ways it’s now the default,” says Christopher Harvey, a senior analyst at Wells Fargo who covers the investment industry.

Column chart of Total net assets, sorted by asset class ($tn) showing Index fund universe has vaulted past $12tn mark

Traditional money management groups have long argued — particularly loudly in the past decade — that they would prove their worth in the next downturn. The coronavirus-triggered mayhem of 2020 has been a perfect opportunity to demonstrate the merits of human “active” management, while staunching the outflows or even beginning to reverse them.

“It’s markets like this . . . where active managers get to show outperformance,” Jenny Johnson, chief executive of Franklin Templeton, told analysts in April. “And as you have outperformance, the flows will follow.”

In contrast, the weaknesses of index funds would be revealed, some industry executives predicted. “The shortcomings of mechanised trading, better known as passive trading, will come into sharper focus,” Peter Harrison, chief executive of Schroders, wrote in the FT in March. “The answers will not be conjured up by arms-length algorithmic investment management.”

‘Active is not dead,’ says Nicolas Moreau, chief executive of HSBC Global Asset Management. ‘The more the market is inefficient, the more active management is important’ © Kai Pfaffenbach/Reuters

Yet, despite such predictions, 2020 looks like it will end up as another muddled year for active management. With a few notable exceptions, the results have mostly been mediocre, with problematic consequences for the industry. “It will further accelerate the demise of traditional active management,” says Yves Bonzon, chief investment officer at Julius Baer, a Swiss private bank.

Asset management executives and analysts expect this to speed up consolidation in the industry, as investment companies seek out the shelter that size offers them. There has already been a spate of deals in recent years. But with the promises to outperform in downturns once again unfulfilled, and likely to reinforce investor scepticism of active management, the battle for market share is set to become even more ferocious.

“Buoyant financial markets lifted asset levels over the past decade, but masked underlying challenges and deteriorating fundamentals at asset managers,” Michael Cyprys, an analyst at Morgan Stanley, said in a recent report on the industry. “We expect the implications of the crisis to have a lasting impact on the industry, accelerate existing trends, and motivate managers to take strategic decisions faster than anticipated.” 

Bar chart of Percentage of funds that have outperformed their index over one, five and 15 years, as of end-June, 2020..  showing Investment funds consistently struggle to beat their benchmarks

A better environment

The investment industry dealt well with many aspects of the Covid-19 pandemic. Shifting thousands of portfolio managers, traders, analysts, risk managers, fund accountants and compliance staff out of the office — at a time when financial markets were in a tailspin — without any major mishaps was an under-appreciated achievement.

“The resilience was a big success,” says Keith Skeoch, chairman of the Aberdeen Standard Investments Research Institute. “Not only did business get done, but liquidity kept flowing . . . A huge amount of money has been raised in the bond and equity markets. The industry continued to fulfil its role in transforming savings into investments.”

However, when it comes to the primary job of a money manager, the record is more blemished. Analysts slice and dice the overall performance of active funds in different ways, which can lead to differing results. Yet one of the most comprehensive, regular snapshots — the S&P Dow Jones Indices’ “Spiva scorecard” — makes unhappy reading for anyone seeking evidence that active management is having a bright 2020.

Only about a third of US equity funds beat the broader market in the year to the end of June. The longer-run Spiva — the S&P Indices Versus Active — results are even grimmer, with under 13 per cent outperforming over the past 15 years. The story is broadly similar for bond funds, despite fixed income markets generally being considered less efficient and therefore offering more opportunities for skilled money managers.

According to Jenny Johnson, chief executive of Franklin Templeton, it’s in turbulent markets like the current one created by the pandemic: “ . . . where active managers get to show outperformance”

Nor has the third quarter helped much. Bank of America estimates that 40 per cent of US equity funds have surpassed their indices in the first nine months of the year. This is narrowly ahead of the 36 per cent long-term average since 1991, when its data began, and the turbulence around the recent US presidential election may have helped. But it means a majority of funds still underperformed their index even in a supposedly better environment and is unlikely to alter the entrenched trend of outflows affecting the industry.

“This has been anything but a normal bear market,” says Michelle Seitz, chairman and chief executive of Russell Investments, pointing to extraordinary central bank stimulus and the dominance of big technology stocks in the subsequent recovery. “I don’t know how valid it is to look at a cycle like this and try to draw too many conclusions from it.”

Line chart of Cumulative net inflows over the past decade, bonds and equities ($tn) showing Passive aggressive

There are important nuances, for example, that active managers generally perform better in certain markets, such as international equities; or in smaller stocks that are less well covered by Wall Street’s army of analysts. “Active is not dead,” says Nicolas Moreau, chief executive of HSBC Global Asset Management. “The more the market is inefficient, the more active management is important.”

Higher returns also mean the sensitivity to performance can be diminished. Investors are unlikely to dump funds that focus on racier “growth” stocks just because they have narrowly trailed behind their benchmark.

Nonetheless, the overall shift into index funds has continued apace — with another $375bn going into passive vehicles in 2020, according to EPFR.

The S&P Dow Jones Indices’ ‘Spiva scorecard’ provides evidence that active management is not having a bright year © Justin Lane/EPA-EFE/Shutterstock

The main driver is the fact that fixed-income ETFs — which some analysts had warned would prove to be fragile in a downturn — performed better in the coronavirus market tumult than many investors had feared, says Sheila Patel, chairman of Goldman Sachs Asset Management.

“A number of institutional investors say they were pleasantly surprised by the liquidity and functionality of using ETFs in March-April,” she says. “So I definitely think it’s cemented a place on the fixed income front.”

Stock market underperformance

Equities remain the hardest area for asset managers to retain investors, and the hurdle is getting higher. In the 1990s the top six deciles of best-performing funds saw inflows, while in the 2000s only the top three deciles did so. In the past decade only the top-decile funds enjoyed positive flows, according to Morgan Stanley.

Even Fidelity’s Contrafund — the world’s biggest actively-managed equity fund — has suffered steady outflows in recent years, despite its manager William Danoff beating his benchmark by an average of over 3 percentage points a year over the three decades he has managed the fund.

Chart shows numbers in bars represents market shares for each investment category showing where the money is going

Underscoring how far the pendulum has swung in favour of passive investing, this summer Coloradan industrialist Clarence Herbst sued the state university’s foundation — which he had previously chaired and donated to — for eschewing index funds in favour of pricier, poorly-performing active funds. The case was thrown out by a Denver judge in October on the grounds that Mr Herbst had no standing to sue, but the fact that it was filed was emblematic of the shifting views of investors.

Tellingly, the shares of most big investment groups have underperformed the broader stock market this year, falling by an average of 2.4 per cent compared with the S&P 500’s 10 per cent gain. Over the past decade BlackRock — the world’s biggest provider of ETFs — is the only US asset manager whose shares have beaten the S&P 500.

Industry executives are aware of the unfavourable data on their overall performance, and know that for a durable active asset management comeback this will need to change. But there is cautious optimism that the coming decade will prove more fertile for their stockpicking stars and bond kings.

Given the prospect of more market volatility, lower overall returns that necessitate a more aggressive approach and widespread economic disruption, the future of active management is brightening, Mr Skeoch argues.

“It’s up to active management to show that it can deliver . . . But I would argue the environment is going to be materially different,” he says. “The opportunity is there, we’ll see if people step forward and take advantage of it.”

Chart shows falling fees raise asset management consolidation pressures

Consolidation picks up pace

Staunching the industry-wide outflows matter because scale is becoming increasingly important for asset managers. Many big institutional investors are trimming how many employees they hire, while wealth brokerages are also culling how many mutual funds they make available to retail investors. Size both means that an asset manager has more sway with potential clients, and that they are better able to pay for their rising costs.

Analysts argue that the turbulence triggered by the pandemic is more likely to shift money between active managers — with those that prove their mettle winning business from underperformers — than arrest the ongoing shift into passive investment vehicles. Morgan Stanley’s Mr Cyprys, estimates that the churn between active managers is actually nearly three times greater than that between active and passive.

Traditional money management groups have long argued that they would prove their worth in the next downturn. Yet, despite such predictions, 2020 looks like it will end up a muddled year for active management © Michael Nagle/Bloomberg

As a result, there has been a spate of mergers and acquisitions. The latest deals involved Franklin Templeton buying Legg Mason for $6.5bn in February; and Morgan Stanley paying $7bn for Eaton Vance to combine it with its own money management arm. The deals catapulted both buyers into the club of groups with $1tn of assets under management.

The former deal in particular represented a doubling-down on a bet that active management is on the cusp of a comeback, according to Ms Johnson. “If you’re driving a car down a well-paved road you don’t need a lot of the safety features. But if you’re going to head to the mountains and you get a snowstorm you’re going to wish you had those safety features,” Franklin Templeton’s chief executive told CNBC in a recent interview. “And that’s what active management is.”

Adding to the sense of an industry shake-up, activist investor Nelson Peltz has taken big stakes in both Invesco — which is still digesting its 2019 purchase of OppenheimerFunds — and Janus Henderson, itself a product of a 2017 merger of Janus Capital and Henderson Global Investors, and is clamouring for further consolidation. At the same time, Société Générale, Bank of Montreal and Wells Fargo are all reportedly looking to sell their asset management arms.

There is plenty of scope for consolidation. Morgan Stanley analysts point out that the 10 biggest investment groups control just 35 per cent of the $90tn industry, making it the most fragmented sector outside of the capital goods sector. They predict that the Covid-19 crisis will further accelerate its consolidation.

Chart showing that most asset management stocks have struggled to keep pace with broader market

“M&A is not a panacea. But strategically combining firms to meet the needs of the capital markets, to meet the needs of the clients and to adapt to the changing landscape is absolutely vital. Every CEO should stay open-minded,” says Ms Seitz, whose company is one of those said to be up for sale by its private equity owner TA Associates.

In addition to bulking up, investment groups are exploring other ways to future-proof their businesses. These efforts include investing heavily in technology to both improve the performance of their fund managers and to cut costs, expanding internationally — with Asia particularly high on the agenda — and accentuating their credentials on environmental, governance and social issues, as ESG considerations become more important to clients.

Yet increasingly, size is seen as the most important imperative.

“The ones with the most amount of assets are going to survive and thrive,” Mr Harvey says. “But if you’re not a behemoth already, it will be tough to become one.”



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Markets

Oil hits highest price since April 2019 before moderating

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The price of crude oil briefly hit its highest level for more than two years on Monday, lifting shares in energy companies, as traders banked on strong demand from the rebounding manufacturing and travel industries.

Brent crude crossed $75 a barrel for the first time since April 2019 before falling back slightly, while energy shares were the top performers on an otherwise lacklustre Stoxx Europe 600 index, gaining 0.7 per cent.

The international oil benchmark has risen around 50 per cent this year, underscoring strong demand ahead of next week’s meeting of the Opec+ group of oil-producing nations.

US manufacturing activity expanded at a record rate in May, according to a purchasing managers’ index produced by IHS Markit. Air travel in the EU has reached almost 50 per cent of pre-pandemic levels, ahead of the July 1 introduction of passes that will allow vaccinated or Covid-negative people to move freely.

“This is a higher consuming part of the year,” said Pictet multi-asset investment manager Shaniel Ramjee, referring to the summer travel season. “And the oil market is pricing in strong near-term demand that is better than previous expectations.”

In stock markets, the Stoxx Europe 600 dipped 0.3 per cent while futures markets signalled Wall Street’s S&P 500 share index would add 0.1 per cent at the New York opening bell.

The yield on the 10-year US Treasury was steady at 1.494 per cent. Germany’s equivalent Bund yield gained 0.02 percentage points to minus 0.154 per cent.

Equity and bond markets have consolidated after an erratic few sessions since US central bank officials last week put out forecasts indicating the first post-pandemic interest rate rise might come in 2023, a year earlier than previously thought.

US shares tumbled last week, while government bonds rallied, on fears of tighter monetary policy derailing the global economic recovery.

Wall Street equities then bounced back on Monday, with a follow-on rally in some Asian markets on Tuesday, as sentiment got a boost from more dovish commentary from Fed officials.

Fed chair Jay Powell, in prepared remarks ahead of congressional testimony later on Tuesday said the central bank “will do everything we can to support the economy for as long as it takes to complete the recovery”.

John Williams, president of the Federal Reserve Bank of New York, also said that the US economy was not ready yet for the central bank to start pulling back its hefty monetary support.

Jean Boivin, head of the BlackRock Investment Institute, said that “the Fed’s new outlook will not translate into significantly higher policy rates any time soon”.

“We may see bouts of market volatility . . . but we advocate staying invested and looking through any turbulence,” Boivin added.

The dollar index, which measures the greenback against trading partners’ currencies and has been boosted by expectations of US interest rates moving higher before other major central banks take action, was steady at around a two-month high.

The euro dipped 0.1 per cent against the dollar to purchase $1.1901, around its lowest level since early April. Sterling also lost 0.1 per cent to $1.3909.



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Wall Street rebounds as markets adjust to Fed rate rise outlook

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Wall Street stocks bounced back and government bonds softened on Monday following tumultuous moves last week after the Federal Reserve took a hawkish shift on interest rates and inflation.

The S&P 500 added 1.2 per cent in early New York dealings. The share index’s resurgence came after it posted its worst performance in almost four months last week in the wake of Fed officials signalling the central bank could raise rates to tame inflation sooner than investors had expected.

The yield on the benchmark 10-year US Treasury bond dropped sharply last week as investors viewed the Fed as ready to control surges in inflation that erode the returns from fixed interest securities. On Monday it rose 0.02 percentage points to 1.472 per cent.

Fed policymakers on Wednesday projected that interest rates would rise from record-low levels in 2023, from their earlier median forecast of 2024. James Bullard, president of the St Louis Fed, told television network CNBC on Friday that the first rate increase could come as soon as next year as inflation grew.

However, Gregory Perdon, co-chief investment officer at private bank Arbuthnot Latham, urged caution. “The facts are that the Fed hasn’t done anything yet. Wall Street loves to climb the wall of worry.”

Fed officials’ statements last week prompted fears of rapid policy tightening by the world’s most powerful central bank that could derail the global economic recovery from Covid-19. Investors also backed out of so-called reflation trades, which had involved selling government bonds and buying shares in companies that benefit from economic growth, such as materials producers and banks.

On Monday, however, energy, basic materials and banking stocks were the best performers on the S&P 500. The technology-focused Nasdaq Composite index was also up, gaining 0.7 per cent in early dealings.

The Russell 2000 index of smaller US companies, whose fortunes are viewed as pegged to economic growth, gained 1.7 per cent. Europe’s Stoxx 600 share index rose 0.7 per cent, with materials stocks at the top of its leaderboard.

The yield on the 30-year Treasury briefly fell below 2 per cent on Monday morning for the first time since February 2020 before bouncing back to 2.065 per cent.

Investors last week had taken profits on reflation trades that had become “crowded” and “expensive”, said Salman Baig, portfolio manager at Unigestion.

Baig added that, following the initial shocks after the Fed meeting, markets would probably return to betting on “a cyclical recovery as economies reopen”.

Other analysts said the bond market reaction had been too pessimistic, predicting a broad-based economic slowdown in response to Fed rate increases that had not happened yet.

The fall in long-term yields “is only justified if the Fed is making a policy error, choking the economy”, said Peter Chatwell, head of multi-asset strategy at Mizuho. “We think this is far from the truth — the Fed has simply sought to prevent inflation expectations from de-anchoring.”

Elsewhere in markets, the dollar index, which measures the greenback against other major currencies, dropped 0.3 per cent after gaining almost 2 per cent last week.

Brent crude, the international oil benchmark, rose 0.9 per cent to $74.18 a barrel.

Additional reporting by Tommy Stubbington in London

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Saudis agree oil deal with Pakistan to counter Iran influence

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Saudi Arabia has agreed to restart oil aid to Pakistan worth at least $1.5bn annually in July, according to officials in Islamabad, as Riyadh works to counter Iran’s influence in the region.

Riyadh demanded that Pakistan repay a $3bn loan last year after Islamabad pressured Saudi Arabia to criticise India’s nullification of Kashmir’s special status.

But the acrimony between the two longtime allies has eased after Imran Khan, the prime minister, met Saudi Crown Prince Mohammed bin Salman in May.

News of the oil deal with Pakistan comes as Saudi Arabia embarks on a diplomatic push with the US and Qatar to build a front against Iran, said analysts. Riyadh lifted a three-year blockade of Qatar in January in what experts said was an attempt to curry favour with the newly elected Joe Biden.

Pakistan had shifted closer to Saudi Arabia’s regional rivals Iran and Turkey, which, along with Malaysia, have sought to establish a Muslim bloc to rival the Saudi-led Organisation of Islamic Cooperation.

Khan has developed a strong rapport with President Recep Tayyip Erdogan, encouraging Pakistanis to watch the Turkish historical television series Dirilis Ertugrul (Ertugrul’s Resurrection) for its depiction of Islamic values.

Ali Shihabi, a Saudi commentator familiar with the leadership’s thinking, said that “bad blood” had accumulated between Riyadh and Islamabad, but recent bilateral meetings had “cleared the air” and reset relations to the extent that oil credit payments would restart soon.

A senior Pakistan government official said: “Our relations with Saudi Arabia have recovered from [a downturn] earlier. Saudi Arabia’s support will come through deferred payments [on oil] and the Saudis are looking to resume their investment plans in Pakistan.”

The Saudi offer is less than half of the previous oil facility of $3.4bn, which was put on hold when ties frayed.

But Fahad Rauf, head of equity research at Ismail Iqbal Securities in Karachi, said: “Any amount of dollars helps because time and again we face a current account crisis. And with these prices north of $70 a barrel anything helps.”

Pakistan’s foreign reserves were more than $16bn in June compared with about $7bn in 2019 before it entered its $6bn IMF programme.

Robin Mills at consultancy Qamar Energy said: “Saudi Arabia and Pakistan are allies, but their relationship has always been rocky. And the Pakistan-Iran relationship is better than you might think.”

Mills said that the timing of the Saudi gesture was “interesting” given that Iran was preparing to step up oil exports with the US considering easing sanctions.

“The Saudis are on a bridge-building mission more generally. They have sought to mend fences with the US and there is also the resumption of relations with Qatar,” he said.

Ahmed Rashid, an author of books on Afghanistan, Pakistan and the Taliban, said that there were a variety of factors that might have spurred Riyadh to restart the oil facility.

It may be “partially linked to the American need for bases” to launch counter-terrorism attacks in Afghanistan from Pakistan, he said, but added that its priority was probably to prevent Islamabad from falling under Tehran’s influence.

Rashid pointed out that Pakistan was caught between China, which has invested billions of dollars in infrastructure projects, and the US.

“Pakistan has to play it carefully, it is dependent on China for the Belt and Road, dependent on the west for loans,” said Rashi. “This is a very complex game.”

Anjli Raval in London and Simeon Kerr in Dubai



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