Active management of equity portfolios has a bright future, but to show that I must first discuss its challenges.
- Traditional active management of equity portfolios was built on enhancing market returns by using skill to select certain factors and stocks. Historically this has provided asset owners with superior risk-adjusted returns.
- Regulatory and technological developments have led to the growth of passive and quantitative investment strategies and also made markets increasingly difficult for traditional active managers to outperform because:
- The information advantage that stock selection was founded upon has been eroded; and
- Technology has industrialised how asset owners can access market and factor returns.
- Factors explain around 25% of active share price movements, the remainder provides a considerable opportunity for active managers to turn into reliable excess return.
- This paper puts forward how active management can be reinvented to remain relevant to asset owners. The proposition is founded on:
- Alpha generation: going beyond traditional analysis of accounting measures by focusing on extra-financial factors - factors that are unique to each business, which lay the foundation of long-term financial and share price performance.
- Efficient portfolio construction: turning alpha generation into sustainable excess portfolio returns.
- This proposition suggests that in order to be successful, active managers need to develop new skills and adopt a long-time horizon. Their success will be predicated on the fact that:
- Any potential excess returns they generate will be generated from stock-specific or idiosyncratic risk, which lies outside the realm of statistical factors; and
- This is a different alpha source, hence it creates a return stream that is not correlated to factor returns.
Please read the full piece here.