Frontier has undertaken a review of active management in the Australian equity market, with a particular focus on the role of active management in a portfolio and the market forces needed for active strategies to benefit.
While the performance of active management in Australian equities has been lower than we would have liked in the past few years, we find the case for active management within an Australian equities portfolio to be reasonably compelling over the longer term.
Our analysis shows the median active Australian equity long-only managers, as measured by those in a Mercer survey, outperformed the index on a net-of-fees basis over both the short and long term.
In addition, analysis of the medium return of managers that are rated buy by Frontier shows they have a strong long-term track record of outperforming both the index and the Mercer median.
Of course, manager selection can make a noticeable difference in active management results.
We also observe that active management does not always outperform the index all the time. Our analysis found that the most recent period of deterioration in aggregate active managers' performances can be explained by market forces and that certain market dynamics are needed for active strategies to be successful.
Our analysis has shown that the following market dynamics are needed for active management to be successful:
- high cross-sectional stock return dispersion,
- high market volatility, and
- low stock return correlation.
Although it is not necessary for these conditions to all be present in the marketplace at the same time for positive active management to be achieved, we find that if any of these elements are missing, active management will not be as successful as it otherwise would be.
Historically, active managers have tended to perform best in a market environment in which the performance of individual stocks varies widely - when there is high cross-sectional stock dispersion. The protracted economic expansion across the globe from 2002 to 2007 has been across all economic sectors, significantly reducing the dispersion in performance of many listed companies.
That is, there was a much reduced dispersion of returns, limiting the return differential between good companies and bad companies. However, over the second half of 2008 and into 2009, cross-sectional dispersion in stock returns has re-entered the market, increasing the opportunity set and effectiveness of successful stock pickers.
The significant repricing of risk has created material opportunities for active managers across all asset classes, including equities, to identify the best performers. It is the unwinding of the 'Great Moderation' (a systematic reduction in the risk premium demanded by investors for any type of risk) that is creating the opportunities going forward.
The capacity of an active manager to outperform is increased where there is high market volatility. There is evidence today that the weighted average volatility in stock returns has started to increase and we believe it is likely to continue to do so going forward.
In addition, it is evident that during the period of economic expansion, the correlation in stock returns was high, making it harder for active managers to pick winners and impacting on their ability to add value.
However, there is evidence to support that periods following a peak in correlation can lead to a strong source of alpha potential. Indeed, history has shown that crises have proved quite positive for active managers, as they have benefited from the eventual market recovery and heightened alpha opportunities.
Therefore, while we acknowledge that the performance of active management in Australian equities has been lower than we would have liked over the past few years, there is evidence active management is beneficial to returns over the longer term.
Further, we believe active management is more likely to add value over the next few years, due to the significant divergence in performance between sectors and companies, and active managers' ability to identify company-specific risks. Increased market volatility and re-rating of risk factors across all sectors should enhance the opportunity set for active management and present greater opportunities for skilled active managers to add value over the coming years.
