Among the great debates in investment circles is active versus passive equity management. Active’s proponents argue that, over a market cycle, professional managers can generate value in excess of their fees while reducing exposure to the market’s worst periods. In contrast, many hold the view that passive management, which emphasises cost, generates better returns that provide compensation for any additional volatility.
Morgan Stanley’s Global Investment Committee examined this question in detail in March 2015 in a paper entitled ‘Active and Passive Strategies: An Opportunistic Approach’*. This research found that neither offers the better choice. Specifically, it found that, across investment styles from large-cap value to small-cap growth, the performance of active managers is cyclical and diverse, and the optimal strategy depends on market conditions. This begs whether active management is likely to outperform after fees.
After re-examining historical data and observing the model in real time, the Global Investment Committee refined its methodology late last year*. We believe the changes will lead to a more effective model and easier implementation.
Removing market bias. Historically, active managers have outperformed when markets are flat or down. Therefore, targeting these periods when managers perform well has some elements of market timing. To avoid this difficult and potentially volatile exercise, we have neutralised the market movements in our models. Instead, we focus on managers’ performances versus historical performance in similar market environments.
Refining factor mix. We have fine-tuned our inputs to the model, adding new factors with incremental information, and dropping overlapping factors. The factors are in the table below. We believe these factors capture a comprehensive picture of the environment for active managers.
Identifying Favourable Conditions for Active Managers
|Yield Slope Level & Trend||Flattening yield slope signals elevated chance of market correction; active has benefited during market downturns|
|Return Correlation Level & Trend||Stock selection is more effective when companies trade distinctly|
|Value Dispersion||Greater difference in price/forward earnings valuations between companies allows active managers to exploit mispriced opportunities|
|Earnings Estimate Dispersion||Controversy among analysts allows for active managers to benefit from research-driven ‘surprise’|
|Modelled Return Breadth||When our model expects strong breadth during the next 12 months, more stocks are expected to outperform; active may benefit given more diverse opportunity|
|Trailing Return Breadth||Strong breadth over the last year has historically meant a narrow market during the following year; fewer opportunities for stock picking|
|Trailing Global vs. US Return||Global stocks gaining momentum may benefit active managers holding companies outside the US|
|S&P Macro Sensitivity Trend||Lower macro sensitivity in the equities market signals more fundamental-driven market environment, likely to benefit active management|
Source: Morgan Stanley Wealth Management GIC
More efficient turnover. Our research found that the outperformance of an average manager in a certain style box tends to be correlated to managers in its same market capitalisation and style cohort. So, if large-cap value managers do well, usually large-cap core and large-cap growth do, too, as do mid-cap and small-cap value.
We therefore modified our model to look across market capitalisation and style groups in order to provide a more consistent signal. When we did this, there were fewer monthly changes. This results in implementation that expresses higher conviction in active positions, while reducing trades that have not been historically successful in generating outperformance.
Centring on the strategic allocation. Our model has reduced active weights in large-caps and mid-caps, with a higher active weight in small-caps. This is mostly due to the change in our tactical allocation methodology; instead of being a standalone signal, our tactical allocation is now based on the strategic allocation we published in September 2015, with tactical overweights and underweights based on market conditions. Strategic allocations are essentially how much active and passive management an investor would place in each style assuming the investor never wants to trade. It’s usually a good idea to lean passive in larger cohorts and active in the smaller ones.
We believe an appropriate active/passive allocation, coupled with suitable allocation by region and effective manager selection, can help achieve the most attractive equity exposure.
For more information on the Global Investment Committee’s Active/Passive model or guidance on how to implement it within your portfolio, speak to your Morgan Stanley financial adviser.
* For a full copy of the original report (Active and Passive Strategies: An Opportunistic Approach) or the update (Topics in Portfolio Construction: Refining Active/Passive), speak to your Morgan Stanley financial adviser.