Why difficult markets demand a high-conviction approach
Investing is an active decision. When investors choose how to allocate their capital, they make an active choice selecting from opportunities at asset class, sector, industry, and security level. In 2018, we are transitioning from a market environment of low interest rates and high liquidity levels to a changed regime that poses new challenges to investors. Mark Holman, CEO of TwentyFour Asset Management, and Roger Merz, Head of mtx Portfolio Management, share their thoughts on active management and why an active approach is particularly important in 2018 if you want to beat the average in the fixed income and equity markets.
Mark Holman: In fixed income, making an active investment decision is about selecting the right amount of risk. Bonds are made up of three types of risk: interest rate, credit and currency risk. Each bond will have a different mix of these risks. When you build your fixed income portfolio, you need to be able to take only the specific amount of each risk you are comfortable with. This is what it means to be an active investor in the fixed income market.
“Making an active investment decision is about selecting the right amount of risk.”
Roger Merz: As an equity investor, I take a different view on this. Exploiting attractive price inefficiencies in the stock markets is at the core of an active investment approach. Valuation is key here. It’s all about identifying the biggest inefficiency at the lowest possible price. Finding these opportunities is challenging since often they don’t occur for obvious, analytical reasons but, on the contrary, for “anti-analytical” reasons, such as short-term market thinking, misunderstanding of a situation and a mismatch between market perception and reality. Such instances lead to fleeting windows of opportunities that a skillful active manager can exploit.
Roger Merz: There are a couple of reasons for that. Since the end of the financial crisis, we operated in a “quasi” one-directional market for a couple of years. In most markets, interest rates were low, company earnings were recovering gradually and developed markets outperformed their emerging counterparts. For several years, investors could make money by buying and holding so called bond-proxy stocks. Often these are defensive companies such as consumer staples that profited strongly from declining interest rates. Since the U.S. has started to raise interest rates, we are facing an increasingly divided world since the EU’s and Japan’s central banks will not match the Fed’s pace when it comes to rate hikes. For equity markets this means higher volatility and a less forgiving market that will differentiate more strongly between winners and losers than before. Most importantly, we expect a style shift in the market to happen. For about 10 years, growth stocks have outperformed value stocks. However, we expect this to change and value as a style to start performing better relative to growth since we are experiencing global synchronized growth which means that investors will be less inclined to pay a premium for growth. Style shifts like these are big opportunities for active investors.
Mark Holman: I agree, active management is essential at this point in the cycle. We are now facing entirely different market conditions to the liquidity glut that followed the financial crisis. Central bank stimulus measures helped all bond markets; interest rates were pushed down and company default rates were low. In that environment most bond strategies – both active and passive – achieved good positive returns, though a good active manager would have outperformed the index. Now we are facing more headwinds, as we are approaching the end of the credit cycle. Interest rates are on the rise and default rates are likely to pick up soon. Right now, 85 percent of the global bond market is problematic in our view. Managers that match the duration exposure of the index will probably lose money this year. For investors this means being more selective. You should carefully select bonds by geography, sector, issuer and type of bond to ensure you take on the right combination of risks as conditions evolve. That flexibility means you can target positive returns throughout the economic cycle.
Mark Holman: The biggest constraint when pursuing an active approach is size. If you have too much capital under management, you cannot be as selective as you need to be. Instead, you are forced to look more like the index, and move into the larger and more liquid parts of the market to deploy all your capital, and you end up taking what the market gives you. Essentially, if you are too big as an active manager, you end up looking more like a passive or index fund, as you don’t have the flexibility to be nimble and execute your desired positioning.
“For an active investor the biggest stumbling block is intellectual arrogance.”
Roger Merz: I believe that for an active investor the biggest stumbling block is intellectual arrogance. In order to invest profitably, you have to take a non-consensus view, sometimes outright contrarian, which feels uncomfortable. In addition, mispricings do not happen often. Therefore, as important as it is for an active investor to find these mispricings, it is equally important to recognize when you are wrong. And why would you be wrong? Because either you drew the wrong conclusions or you don’t have the right timing. Both will cost you money. So, as an active investor it is crucial to cultivate convictions but at the same time to stay humble and relinquish your beliefs when, in fact, the market turns out to be right. The most successful active investors tend to be those that make the fewest mistakes.
Roger Merz: Sure.If you want to outperform the benchmark, one approach is to buy companies of higher quality at a lower valuation and with lower risk than the average benchmark company which a passive index investor ends up with. More specifically, companies with a high return on their invested capital, that can grow these returns further as a result of their strong competitive position, represent attractive opportunities for investors. Having said that, active investing is not a certainty but always a probability business. So, you line up as many things as you can that are likely to turn out in your favor. This will increase your probability of success. Howard Marks, the famous distressed investor, said once: “It is the investor’s job to intelligently bear risk for profit.” This is exactly what active management is all about.
Mark Holman: The bond market is vast and varied and offers countless opportunities for an active investor. A major bank like Barclays, for example, has over 1,000 different outstanding securities spanning a multitude of maturities and risks. As an active investor you may want to target the specific risks, structural idiosyncrasies and certain parts of a company’s capital structure and select bonds accordingly. This way you can fine tune the risk-reward profile of your portfolios, and find relative value to boost returns.