The importance of active management in times of uncertainty

By Ashfaaq Aboobaker, Head of Investment at Stewards Investment Capital

Since the global financial crisis of 2008, financial markets have evolved in an environment overflowing with liquidity and devoid of prolonged recessionary or systemic shocks. 

We are now in the 17th year of this bull market, which has undoubtedly suffered major shocks (Greece 2011, Covid, etc.). The difference to previous periods is the relatively short-lived tenor of these « risk off » periods. Liquidity in the form of coordinated monetary policies from central banks have provided the necessary fuel for markets in general during this exceptional period. 

 

Active capital management, which brings dynamism and adaptability to asset selection and appropriate risk management, has become imperative. 

 

Traditionally uncorrelated assets have reached an unusually high level of correlation due to these policies. The result of this excess of positive correlation has greatly favoured passive strategies which, regardless of the sector, the type of investment or the timing of the investment, have provided significant returns, equivalent to those of the best managers, sometimes buying anything and everything. 

We are now entering a different economic regime. 

The central banks’ tools to support this upward trend and cushion any forward shocks have lost their effectiveness due to the gigantic size of the economic stimulus already disbursed. 

Interest rates are starting to reflect a general rise, and gold is taking over from the major currencies of sovereign countries, which are indebted as never before. We have also entered a new technological area, that of artificial intelligence, which is imposing rapid and real changes on multiple industries. Inflation is pointing its nose and geopolitical crises are becoming more frequent and severe, as the current conflict in the Middle East suggests. 

We are also witnessing a slow collapse of the old global economic system, centred around the United States, to a more fragmented and regional economic system, where China, Russia and India are taking the lead roles. 

In a market environment where volatility is increasing and where the usual mechanisms of economic flows are disrupted, the asset selection and the choice of the investment strategy are once again becoming essential. 

Passive management is appropriate for long periods of increases punctuated by short corrections of relatively small magnitude and low volatility. These strategies, by their definitions and structures, are unsuitable for pivotal periods or changes in capital market regimes. In these moments, the flexibility of your strategies and the know-how and the experience of your investment manager becomes the essential tool for preservation and growth of your capital. 

Benefits of an active management. 

Active portfolio management is primarily intended to generate performance regardless of the economic situation. It aims to beat the market by identifying underestimated opportunities and risk situations to generate superior returns.

Outperformance 

Active management aims at beating the market (a benchmark index or portfolio). A good investment manager can identify undervalued assets as opportunities and use these opportunities to generate higher returns. Unlike passive management, which simply replicates an index and therefore its average performance even in times of decline, an active management strategy is designed to outperform. 

Flexibility 

An active manager can adjust the portfolio exposure to the markets depending on the prevailing conditions and levels of risk. For example, he can quickly reposition his portfolio in the event of a crisis or increase his positions during a bull run. Passive management remains invested in the same way, whether the markets are rising or falling, and follows, with rigidity, a predefined and unalterable strategy. 

Targeted asset selection 

Active management, by definition, makes it possible to optimize the selection of assets. It makes it possible to avoid certain risky companies or sectors, to focus on specific themes (ESG, innovation, etc.) and to diversify by providing a selection of alternative assets or to “customise” the allocation to the needs of the investor. Passive management invests in the entire index, including underperforming companies and does not diversify risk by employing uncorrelated assets. 

Access to inefficient markets, emerging trends or alternative assets 

In some markets (small caps, emerging markets, etc.), information is not completely integrated into prices. Active managers can find inefficiencies and generate value by using their experience and know-how. Experienced managers can also identify emerging trends and include uncorrelated assets to generate performance even in times of decline. A passive portfolio manager will not benefit from these advantages, which are linked to the manager’s know-how and dynamism.

Finer risk management.

Active management can adapt and adjust portfolio volatility, implement hedging and protection strategies, diversify dynamically and adapt to specific objectives. It is more suitable for personalized objectives (revenue, growth, capital preservation), tax or regulatory constraints. 

A passive portfolio cannot provide a dynamic risk strategy and exposes the investor to an increase in the volatility, prolonged drawdowns and concentrated risks, specific to an asset class, something we often see during financial crises. 

Active management, an imperative in times of uncertainty.

Passive management has experienced breathtaking growth in terms of assets under management over the past decade, as evidenced by the size of ETFs and managers such as BlackRock. 

Positive correlations between traditionally uncorrelated asset classes are at unusually high levels. They have allowed many passive strategies to deliver decent returns with very little effort and lower-quality assets, strategies and risk management. 

The development of these passive strategies has introduced devious and underestimated effects. Overweighting a handful of assets or sectors, inflating valuations (the example of Nvidia, worth as much as Japan’s GDP, comes to mind), declining effective price discovery, as well as misleading diversification have introduced underestimated systemic fragility. 

At a time where financial markets are starting to show signs of vulnerability, it is essential for any portfolio to find a balance. Passive investing is no longer the only answer to responsible management. Active capital management, which brings dynamism and adaptability to asset selection and appropriate risk management, has become imperative. 

In times of volatility and uncertainty, it is vital to have the expertise of a manager who can protect your capital, accompany you, and allow you to take advantage of the market opportunities that a passive portfolio can never offer.