Is the Tide Starting to Turn for Active Managers?

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1 PRUDENTIAL INVESTMENTS, A PGIM BUSINESS Strategic investment research group Is the Tide Starting to Turn for Active Managers? FEBRUARY 217 After roughly seven years of experiencing subpar returns from active large cap equity managers, we have seen a pronounced shift away from active strategies towards passively managed index funds and ETFs. 216 was an especially difficult year with only 22% outperforming their benchmarks 1. The inability of active managers to outperform the index confirms for some investors what a segment of the investment community says is an impossible task to outperform the market after fees. Our perspective is that active management has always been a difficult task, requiring investors to identify skilled managers with a competitive edge. Performance has, admittedly, been atypically poor over the past few years. However, we don t think that recent challenges represent a secular decline in the art of stock picking. Rather, many of the headwinds that active managers have faced are attributable to market conditions that are temporary and not structural. Within this context, we will explain the drivers of active manager performance, market dynamics over the past five years, and why we believe these headwinds are starting to fade. BACKDROP Over the long run, investing in the median active manager tends to underperform by an amount roughly in line with their fees. That being said, investors who have been successful in identifying skilled managers have been rewarded for it. Over short and even intermediate time periods, however, the performance of active management has been cyclical. Recently, active equity managers have hit a rough patch. As shown in Figure 1 below, active large cap equity mutual funds have had a tough time outperforming their benchmarks since 21. Even top quartile managers have struggled to generate significant excess returns after fees. As a result, investors have increasingly favored passive investments. For perspective, roughly $846 billion has flowed out of active equity mutual funds since the credit crisis. Passive funds and ETFs have seen inflows of $971 billion 1. Figure 1: Large Cap Equity Funds: Rolling 1-Year Excess Returns 2 15 Top Quartile Median Rolling 1-Yr. Excess Return Tech Bubble Post Credit Crisis 1 Late '8s Source (as of 12/31/216): SIRG, Morningstar Direct 1 Source: Morningstar Direct as of 12/31/216

2 The recent performance struggles for active managers are not unprecedented. We ve identified three periods going back to the 198s. The last period of similar difficulty, in terms of both duration and magnitude, was during the dot.com stock bubble of the late 199s. This was a period characterized by rapid growth in the stock market, driven by a speculative bubble in internet-oriented stocks. Valuations reached levels that were out of line with any reasonable assessment of the companies ability to generate future cash flows. Active managers were generally underweight this segment of the market, and struggled to keep up as the bubble inflated. They subsequently outperformed by a wide margin when the bubble burst in early 2. The recent period of underperformance feels similar, albeit for different reasons. Rather than market valuations being distorted by a speculative bubble in tech stocks, today it s about an unprecedented degree of central bank involvement in markets. In the immediate aftermath of the Global Financial Crisis, central bankers responded aggressively with a number of programs to restore liquidity and stability to financial markets. Even now nearly 8 years past the crisis, monetary policy globally remains extremely accommodative against a backdrop of generally sluggish economic growth. For example: The US Federal Reserve started cutting the Fed Funds rate in September of 27, and held it near zero from December 28 to December 215. Even now that the Fed has started the process of raising short-term rates, the pace looks to be slow relative to history. In addition to cutting interest rates, the Fed used its balance sheet to purchase both government bonds and mortgage-backed securities in an effort to aid liquidity and lower interest rates (Figure 2). The first round of Quantitative Easing (QE1) was initiated in December 28 and extended in March 29. Subsequent rounds of quantitative easing were later implemented through QE2 (November 21 to June 211) and QE3 (September 212 to December 213). Additionally, with Operation Twist in September 211, the Fed extended the maturities of securities in its portfolio in an effort to flatten the yield curve. Quantitative easing programs were also implemented by other major central banks including the Bank of England, the Bank of Japan, and the European Central Bank. Finally, negative interest rate policies ( NIRP ) were adopted by central banks in the Eurozone, Japan, Denmark, Switzerland, and Sweden. NIRP essentially works by charging banks to keep excess cash with the central bank. This, in turn, is expected to incentivize banks to lend more, thereby reducing borrowing costs for both companies and consumers. Unprecedented central bank actions have distorted market prices Figure 2: Growth of Central Bank Balance Sheets (28 = 1) 6 5 ECB Fed BoJ Source (as of 7/31/216): Bloomberg Figure 3: Selected Government Bond Yields (%) Country 2 Year 5 Year 1 Year United States Italy (.19) Canada Spain (.32) United Kingdom France (.72) (.31).68 Sweden (.63) (.12).55 Germany (.8) (.54).2 Japan (.19) (.11).4 Source (as of 12/31/216): FactSet Research Systems, Inc. FEBRUARY 217 2

3 One result has been extremely low, even negative, interest rates across the developed world (Figure 3). It s not only bond markets that were impacted. The US equity market is now after 7+ years in the second-longest bull market on record, as investors were forced into riskier assets to meet return objectives (Figures 4 & 5). Against this backdrop, the typical playbook used by active managers hasn t worked. Elevated equity valuations as bull market continues Figure 4: S&P 5 Price Index Figure 5: Cyclically Adjusted Shiller P/E 2,5 5 2, 1,5 1, Average Source (as of 12/31/216): FactSet Research Systems, Inc., Standard & Poor s Source (as of 12/31/216): FactSet Research Systems, Inc., Standard & Poor s, Robert Shiller A CHALLENGING ENVIRONMENT FOR ACTIVE MANAGERS What is it about the current market environment that has been so difficult? A good place to start is with The Fundamental Law of Active Management, first developed by Grinold in 1989 and later refined by Grinold and Khan in 1995 and 1999, and Clarke, de Silva, and Thorley in 22. The Fundamental Law provides a useful framework to think about investment manager performance. The idea is that risk-adjusted performance is a function of a manager s skill (as defined as the ability to correctly forecast security returns), the breadth of independent investment opportunities available, and the ability to translate their forecasts into portfolio positions. In short, to outperform the benchmark active managers need some sort of forecasting edge, opportunities to apply this edge, and be able to implement their ideas into a portfolio at appropriate weights. Market dynamics over the past several years have made this difficult for a variety of reasons: Quantitative easing compressed market volatility, resulting in a lower than normal payoff from successful stock selection. Markets have been driven by macroeconomic factors rather than fundamentals most active managers forecasts are based on fundamental analysis rather than top-down macro factors. Common portfolio construction biases found across a large number of active portfolios have been a headwind. As we will detail below, none of these factors are likely to be a permanent feature of the investment landscape. Rather, they are symptoms of the post-financial crisis market environment, notably the unprecedented magnitude of central bank involvement in markets which are likely to be cyclical rather than secular. And finally, there have been some recent indications that the tide is starting to turn. FEBRUARY 217 3

4 Lack of market volatility limits alpha opportunities Active managers attempt to overweight stocks they believe will be the best performers going forward, and avoid or underweight the worst performers. Accordingly, stock price dispersion the spread between the best and worst performing stocks is one way to measure the potential value-added from stock selection. When stock price dispersion is high, more alpha is up for grabs, when it s low, alpha is harder to come by. Indeed, as Figure 6 shows, stock price dispersion tends to be highly correlated with the dispersion between top quartile and bottom quartile mutual fund performance. When stock price dispersion is high, so too is the spread between the best and worst performing equity managers and vice versa. Figure 6: Return Dispersion S&P S&P 5 Intra Stock Dispersion Large Cap Equity Funds Excess Return Dispersion Source (as of 12/31/216): SIRG, FactSet Research Systems, Inc., Standard & Poor s, Morningstar Direct Large Cap Equity Funds A side-effect of central bank intervention in markets is that quantitative easing programs suppressed market volatility, particularly from 212 (when QE2 was announced) to mid-215 (as markets started anticipating the first rate hike by the Fed). As a result, the reduced payoff from stock selection was one headwind to active managers, particularly after the impact of management fees. Macro-driven markets make life difficult for fundamental investors The past several years have also been characterized by elevated economic uncertainty (Figure 7). Stocks within the broad equity market have shown a higher than normal tendency to move in tandem (Figure 8), implying that macroeconomic rather than company-specific news is driving stock prices. This risk-on/risk-off dynamic has been challenging to most managers in that the traditional fundamental tools they use to forecast security returns have been less effective in recent years. Most active managers focus on company-specific fundamentals, factors such as valuation or expected earnings growth. It s particularly difficult to profit from stock-specific insights when everything is moving together, in response to changes in expectations about central bank policy, for example. Macroeconomic uncertainty impacts the stock picking environment Figure 7: US Economic policy uncertainty index Source (as of 12/31/216): SIRG, FactSet Research Systems, Inc., Economic Policy Uncertainty Figure 8: S&P 5 Intra-Stock Correlation Rolling 6-Month Periods Source (as of 12/31/216): SIRG, FactSet Research Systems, Inc., Standard & Poor s FEBRUARY 217 4

5 Against this backdrop, the typical playbook of bottomup research has been less effective. Over the long run, investors have been rewarded for superior fundamental analysis. Figure 9 plots the performance of stocks in the large cap US equity market for the month following an earnings announcement. Quintile one shows the performance of stocks with the largest positive earnings surprises, while quintile five shows the performance of stocks with the largest negative earnings surprises. Over the long term (the blue bars) investors have been rewarded for forecasting earnings better than the market quintile one stocks outperform quintile five. Since 21 (the red bars), this hasn t been the case. Investors haven t been getting paid for superior forecasting ability. Figure 9: Performance Impact of Earnings Surprises Average stock return one month following surprise date Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Biggest beats Source (as of 12/31/216): SIRG, FactSet Research Systems, Inc. Largest misses One clear recent example is the outperformance of higher dividend yield / lower volatility stocks in the first half of 216. These types of companies outperformed largely due to increased demand for current income in a low interest rate environment (Figure 1) and a desire for downside protection. Active managers were underweight this segment of the market, which generally underperformed over the period. Falling rates...rising valuations for high dividend stocks Figure 1: 1-year us treasury bond yield Source (as of 12/31/216): FactSet Research Systems, Inc. Figure 11: Relative P/E of High Div Yield Stocks vs. R Source (as of 12/31/216): SIRG, FactSet Research Systems, Inc., Russell Investment managers interviewed by SIRG have generally been underweight the safety trade in recent years. On a fundamental basis, higher dividend yielding stocks looked expensive relative to history (Figure 11) and earnings growth expectations are considerably lower than those of the broad market. Also, there was a sense of concern that when interest rates do rise, bond proxies are vulnerable to underperformance. It happened during 213 s taper tantrum and more recently with increasing inflation expectations, which accelerated following Donald Trump s victory in the US presidential election. FEBRUARY 217 5

6 Portfolio construction challenges Active equity managers have also faced portfolio construction challenges in recent years. There are biases that tend to be common across a large number of active managers portfolios. These biases do a pretty good job of explaining the performance of active managers in aggregate. While it doesn t account for individual skill, it does capture the impact of market factors which can be headwinds or tailwinds across a large number of strategies. Common portfolio biases explain performance of active managers Cash Drag T-bills vs. S&p 5 Less Mega Cap Exposure Top 25 stocks underperform Exposure to Small Caps Russell 2 outperforms s&p 5 Exposure to Non-us Stocks msci eafe outperforms s&p 5 Fund managers hold some cash to meet redemptions. This can be a drag on performance during stronger than average up-markets. Manager s biggest active positions tend to be outside the largest names in the benchmark. Narrow markets can be a headwind. Active managers often have some exposure to smaller cap stocks relative to the benchmark. Active managers often have some non-benchmark exposure to international equities. Over time, the aggregate performance of these factors tends to be cyclical, as shown below. Sometimes they help, sometimes they hurt but, collectively, they are rarely headwind for an extended period of time. Two notable exceptions were the Tech Bubble and the recent post-crisis environment. Figure 12: Common Portfolio Biases Have Been a Headwind for an Unusually Long Period 2 1% Active Bias Index 1 Tech Bubble Post Credit Crisis 75% 5% % Outperforming 1 25% % Active Bias Index (Left) % of Large Cap Equity Managers Outperforming (Right) Source (as of 12/31/216): SIRG, Standard & Poor s, Russell, MSCI, Morningstar Direct The Active Bias Index is calculated by averaging the Z-Scores of each component over rolling 1-year periods. Z-Score: A standard score indicating how many standard deviations an observation is above or below its mean. FEBRUARY 217 6

7 Both periods were characterized by stronger than average bull markets. As is shown in Figure 13, any cash held to meet redemptions was a drag on performance. Furthermore, both periods were characterized by strong outperformance of US stocks vs. other developed markets, making any non-us exposures a headwind. The tech bubble period was a bit different in that smaller cap stocks were largely left behind in a market dominated by large cap US tech stocks. The point remains however, that periods of relatively narrow market leadership tend to be more difficult for active managers. Figure 13: Annualized Factor Performance vs. Long Term Average 11.6 Tech Bubble Jan-95 Dec Cash Drag Less Mega Cap Exposure 4.5 Current Environment Jan-1 Dec Exposure to Small Caps Exposure to Non-US Stocks 4.6 Source (as of 12/31/216): SIRG, Standard & Poor s, Russell, MSCI, Morningstar Direct In recent years, we estimate that the roughly 2% cash position that is fairly typical for an active strategy has resulted in roughly 2 bps of underperformance on an annualized basis. The roughly 4.%-4.5% average allocation to non-us stocks has cost an annualized 2-5 bps. Figure 14: Impact of Style Headwinds on Relative Performance January 21 December 216 WHERE DO WE GO FROM HERE? While the past several years have been particularly challenging for active investing, we don t believe that the effectiveness of fundamental analysis is dead. Prices can be volatile over short and intermediate timeframes, but over the long run, they follow earnings. Figure 15: Stock Prices Follow Earnings Large Core Large Growth Large Value Impact of cash drag Impact of non-us exposure Total Source (as of 12/31/216): SIRG, FactSet Research Systems Inc, Lipper 5, 14 4,5 4, S&P 5 Total Return Index S&P 5 Earnings per Share 12 S&P 5 Total Return Index 3,5 3, 2,5 2, 1, S&P 5 Earnings per Share 1, Source (as of 12/31/216): FactSet Research Systems Inc., Standard & Poor s FEBRUARY 217 7

8 Furthermore, there are reasons to be optimistic that the tide will turn. The market environment over the next five years is likely to be quite different from what investors have experienced since the credit crisis, and considerably more challenging. Figure 16 decomposes the historical performance of the S&P 5 into three components: Earnings growth: the portion of the market s performance that was driven by changes in earnings expectations for the next 12 months. Change in valuation: the portion of the market s performance that was driven by changes in how much value investors place on each dollar of expected earnings (changes in the P/E ratio). Dividends: the portion of total return that comes from dividends rather than price appreciation. Figure 16: Annualized Performance 21% 2.5% 4% 14.4% 2.3% 7% 4.4% 14% March 9 Dec 12 Dec 12 Dec 16 Earnings Growth Change in P/E Dividends Total Return Source (as of 12/31/216): SIRG, FactSet Research Systems Inc, Standard & Poor s The early stage of the current bull market was driven by the earnings recovery coming out of the great recession. As the bull market moved into later innings, loose monetary policy and a low rate environment helped keep the bull market on track largely due to P/E expansion, which is a more difficult environment for active investors. Given where valuations are today, investors can t rely on continued multiple expansion to propel the markets higher. Figure 17 plots the starting valuation of the S&P 5, as measured by the cyclically adjusted earnings yield, versus its realized real (after inflation) return over the subsequent 1-year period. Historically, elevated valuations like we have today result in lower long-term returns. Figure 17: 1-Yr. S&P 5 Real Returns vs. Starting Valuation 25 Subsequent Real 1-Year Equity Return Current Earnings Yield 3.53% % 5% 1% 15% 2% S&P 5 Cylically Adjusted Earnings Yield Source (as of 12/31/216): SIRG, FactSet Research Systems Inc, Standard & Poor s, Robert Shiller FEBRUARY 217 8

9 Two implications of a low return environment for investors: First, as demonstrated in Figure 18, lower return environments tend to be more favorable for active management. While active managers struggle during particularly strong up-markets, they don t face the same headwinds in lower or negative return environments. Second, in a low return environment, alpha from active management can be a much needed addition to total returns. Figure 18: Average Large Cap Fund Excess Return in Various Return Environments.7%.2% Finally, there have been recent signs that the tide is starting to turn. While monetary policy still remains extremely accommodative, the US Federal Reserve has been continuing on its path (albeit slowly) of normalizing the Fed Funds rate. Furthermore, investors are starting to doubt the prospects for further monetary stimulus from the ECB and BoE. We don t believe that monetary policy has to completely normalize for the stock picking environment to improve. Rather it s more about the market and the central banks being on the same page with respect to Big Down Quarters: S&P 5 < 4% Trading Range: S&P 5 +/ 4%.19% Big Up Quarters: S&P 5 > 4% Source (as of 12/31/216): SIRG, Morningstar Direct. Returns are gross of investment management fees. the likely direction of monetary policy. Surprises have led to risk-on/risk-off dynamics in markets which have created challenges for bottom-up managers. For example, we came in to 216 with market participants expecting three or four rate hikes, and we ultimately got only one. Market performance in the second half of 216, especially following the US presidential election, has generally been more favorable for active large cap equity managers. In the second half of 216, roughly 45% of large cap equity managers have outperformed their benchmarks, a bit better than the long-term average. Some of the factors which contributed to performance: Defensive, bond proxy stocks have struggled given expectations for fiscal stimulus (Figure 19), while small cap stocks and companies that were cheap on fundamental valuations metrics such as Price to Earnings or Price to Book have rallied. Stock price dispersion has been returning to more normal levels, which implies alpha potential for successful stock selection (Figure 6). Intra-stock correlation has decreased, indicating that differences in company-specific news and fundamentals are starting to have a greater impact on stock prices than broad macroeconomic themes (Figure 8). FEBRUARY 217 9

10 Some of the headwinds for active strategies are starting to fade Figure 19: Bond proxy trade performance (Indexed to 1) Utilities, Consumer Staples, Telecom and Real Estate vs. S&P Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Source (as of 12/31/216): SIRG, FactSet Research Systems Inc. That s not to say that challenges don t remain. Flows towards passive strategies, which have likely exacerbated many of the headwinds active managers have faced, are not likely to abate. Also, macroeconomic event risk will continue to impact markets over shorter time frames. However, all things considered, we don t believe now is the time to throw in the towel on active management. Figure 2: % of Large Cap Equity Managers Outperforming 51% 6% 21% 14% 11% 1984 to to to to to 216 Source (as of 12/31/216): SIRG, Morningstar Direct The performance of active management is cyclical. Periods of prolonged difficulty for active managers tend to correspond to extreme market events and major dislocations in market prices. History teaches us that ultimately fundamentals matter, and there are signs that things are starting to move in the right direction. FEBRUARY 217 1

11 Disclosures Indices are unmanaged and an investment cannot be made directly into an index. The S&P 5 Index consists of 5 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock s weight in the Index proportionate to its market value The MSCI EAFE Index is a market capitalization weighted index composed of companies representative of the market structure of 22 Developed Market countries in Europe, Australasia and the Far East. The Russell 2 Index measures the performance of the 2, smallest companies in the Russell 3 Index. The Russell 1 Index consists of the 1, largest securities in the Russell 3 Index, which is composed of the 3, largest U.S. securities, as determined by total market capitalization. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI s express written consent. The Global Industry Classification Standard ( GICS ) was developed by and is the exclusive property and a service mark of MSCI, Inc. ( MSCI ) and Standard & Poor s, a division of The McGraw-Hill Companies, Inc. ( S&P ). GICS classifications and related GICS information are provided as is with no express or implied warranties. 217 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Morningstar Large Value Category: funds that invest primarily in big U.S. companies that are less expensive or growing more slowly than other large-cap stocks. Stocks in the top 7% of the capitalization of the U.S. equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow). Morningstar Large Blend Category: funds are fairly representative of the overall U.S. stock market in size, growth rates, and price. Stocks in the top 7% of the capitalization of the U.S. equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. Morningstar Large Growth Category: funds invest primarily in big U.S. companies that are projected to grow faster than other large-cap stocks. Stocks in the top 7% of the capitalization of the U.S. equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). Cyclically Adjusted Shiller Price/Earnings (CAPE): a valuation measure that uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle. Stock Correlations: a statistical measure of how securities move in relation to one another and is the average of all of the individual stock correlations of the constituents of the S&P 5 Index. Stock Return Dispersion: measures the dispersion in individual stock returns relative to the return of the overall Index. Alpha: the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). Mortgage Backed Security: A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy. Quantitative Easing: Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Operation Twist: A policy action by which the Federal Reserve sold short-term government bonds and bought long-dated Treasuries, in an effort to lower longer term interest rates. Yield Curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 3-year U.S. Treasury debt. Price-earnings ratio (P/E Ratio): A ratio for valuing a company that measures its current share price relative to its per-share earnings. Price-to-book ratio (P/B Ratio): A ratio used to compare a stock s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter s book value per share. FEBRUARY

12 This report is produced by the Strategic Investment Research Group (SIRG), a unit of Prudential Investments LLC, and a research unit of Prudential Financial. SIRG provides research, analysis and due diligence on investment management firms and the vehicles and strategies they offer. The information contained herein has been obtained from sources that Prudential Financial believes to be reliable. Prudential Financial does not guarantee the accuracy or completeness of data received from outside sources, including investment managers. Diversification and asset allocation do not guarantee a profit or protect against a loss in declining markets. Investing involves risks. Some investments have more risk than others. The investment return and principal value will fluctuate and the investment, when sold, may be worth more or less than the original cost and it is possible to lose money. Past performance is not a guarantee of future results. Since no one manager/investment program is suitable for all types of investors, this material is provided for informational purposes only. Clients investment objectives, risk tolerances, and liquidity needs must be reviewed before introducing suitable manager/investment programs. Fixed income investments are subject to interest rate risk, where their value will decline as interest rates rise. Foreign investing may involve currency risks, and investing in less developed countries may produce risks related to market structure. Indices are unmanaged and an investment cannot be made directly into an index. CONTACT US For questions, us at investment.research@prudential.com or visit us online at Consider a fund s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and summary prospectus. Read them carefully before investing. 217 Prudential Financial, Inc. and its related entities. Prudential Investments, Prudential, the Prudential logo, Bring Your Challenges and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide SIRG23 Expiration 7/31/218 FEBRUARY 217