Can active managers outperform when the global economy slows?

Higher interest rates and slowing consumer spending are bringing a much wider dispersion of company earnings and stock returns. This gives active global equity managers the opportunity to outperform by concentrating their portfolios on the most exciting investment ideas.

“You always want to think what not to do if you want to beat the index”
Francois Rochon, co-founder Giverny Capital

Whatever happened to active management?

In recent years, stock market returns were largely driven by central bank policy. During the free money era of near-zero interest rates, share markets were highly correlated, appreciating fairly consistently. During this time, it mattered a lot less where you invested. Hence, many investors began to question the value of paying investment fees to active managers.

There is much less price discrimination in a low interest rate environment. Even highly leveraged, low-growth zombie companies were able to service debt and deliver some immediate profits when money cost nothing and the global economy kept growing. Low-cost passive investment strategies were the obvious solutions for many investors during this period.

So why is active management now back?

The easy gains that came from free money are alas, now well and truly over!

Persistent inflation, higher interest rates, deglobalisation, and government policies (such as greater regulation or populist trade and tax measures) are impacting different stocks in very different ways. This means that earnings between different regions, industries, business models, and companies are now showing much greater variation from one another.

Different companies adapt their strategies, implement technological change, and evolve their brands in different ways and to varying effects. In a rapidly changing market environment, this brings further dispersion in earnings and stock returns.

What does the slowdown mean for stock returns?

A wider spread in the returns of individual companies, sectors, and markets was clearly visible in the market rally of the first six months of 2023. Gains were concentrated in a very limited number of stocks during this time, which were typically those with strong competitive advantages in markets that were subject to rapid expansion on a large scale.

It is critical that an investment manager’s process is able to identify ahead of time the exceptional and sudden growth in specific markets and the companies able to thrive in them as the economic environment rapidly evolves. It can then allocate significant capital to the most exciting companies.

The Pengana Axiom International Funds analyse hundreds of forward data points across economies, sectors, and companies. These provide portfolio managers with early indications of how macroeconomic factors and secular growth trends – such as AI, decarbonisation, automation, or the ageing population – can impact a company’s earnings.

Many investors focus on anticipating small variations away from the near-term earnings guidance issued by companies and analysts, to identify stocks that may be a bit under (or over) valued. Such an approach allows itself to be guided by consensus expectations. This can miss the quantum change that transformative technology brings to the total addressable market size of a very limited number of companies.

Axiom’s process identified early the market opportunities that innovation in weight loss drugs and accelerated computing would bring to companies such as Novo Nordisk and Nvidia respectively. This helps to capture returns in periods when they are highly concentrated in a limited set of stocks, such as when the economy slowed in 2023.

What does this mean for global equity investors?

Periods of high and changing interest rates and economic slowdown bring greater dispersion in stock market returns. This is an opportunity for active investors to perform well.

Successful active investors concentrate on a limited set of the very best investment ideas. They are now choosing not to invest in businesses that are more likely to be impacted by falling consumer spending, high borrowing costs, and disruptive innovation.

In challenging markets, diligent and ongoing analysis and portfolio management – rather than a set and forget approach – can genuinely add value. While different investment approaches may have merit, investors should get clear on whether they wish to pay a manager to deliver market exposure, factor investing, or genuine investment skills.

Genuine skill – in delivering the investment outcomes that are promised over time – is uncommon and carries a cost, but can increase long-term risk-adjusted returns.

Tim Richardson CFA, Investment Specialist