Harnessing the data science revolution

A mass of new information types, combined with new methods of analysis is giving investors the tools to enhance long-term performance, argue Ben Wicks, Head of Data Insights and Research Innovation, and Mark Ainsworth, Head of Data Insights and Analytics, both Schroders.

The process of collecting and analysing data has undergone a revolution. A mass of information, from geospatial data to customs records and demographic data, is now available and can be manipulated in ways unheard of 30 years ago. Investors who can marry industrial-scale data processing with tried and tested investment expertise will emerge as winners.

The dramatic increases in computer processing power, storage capacity and information mean that the amount of “alternative data” that can potentially be interpreted by an analyst or fund manager is growing at an exponential rate. These developments pose disruptive challenges to the investment industry. But they also provide a major opportunity.

A positive role to play

Alternative data is an umbrella term for information that is not already part of the core currency of investment research, being, broadly, everything that is not company accounts, security prices or economic information. Because alternative data is often unstructured, it may need considerable processing before it can yield meaningful conclusions. A cadre of data science professionals has emerged to meet this challenge and fashion the necessary techniques to handle large data sets.

Good data scientists have several distinct qualities. A sound knowledge of maths, statistics, programming and algorithms is essential. But a firm understanding of the security under consideration, where the data is from and the way in which it is being applied are equally valuable for understanding what really matters. Combining an investor’s deep knowledge of the market and securities with skilled data scientists, whose specialised work becomes part of the investment process, is optimal.

Perhaps the biggest impact of data science on the active manager is capacity, by the freeing up of time and intellectual capital. A comparison can be made with the impact of avionics on pilots: the information provided by advanced instrumentation provides for better decision-making and liberates the pilot’s mind to do other things that improve overall performance, such as contingency planning. Similarly, an investor who can rely on other specialists to help extend their vision in all the above ways will be that much freer to think and explore fresh ideas.

Scale and resources

The proliferation of information available for investment research is a profoundly disruptive force. Data science poses technical and organisational challenges and involves substantial research and development work. But data science also offers a huge opportunity for active fund managers.

The injection of new, and potentially unique, methods of data analysis into existing investment processes should enhance long-term performance.

Organisations that successfully adapt to this data-heavy world will have a mind-set of innovation and collaboration. They will also be large enough and have sufficient technological prowess to compete. The scale and variety of the data available today requires considerable engineering and data management resources if it is to be used optimally. Larger teams of data scientists will be able to exploit large volumes of data from diverse sources in ways that would be more difficult for a single data scientist acting alone.

Far from creating a level playing field, where more readily available information simply leads to greater market efficiency, the impact of the information revolution is the opposite. It is creating hard-to-access territories and opportunities for those few players with the scale and resources to take advantage of it.

To read the full report as a PDF, click here.

This article has first been published on schroders.com.

Yin and yang: how private assets and derivatives can work together

Data suggests that many institutions would benefit from higher allocations to private assets, but that liquidity constraints often limit their use. Jon Exley, Solutions Manager at Schroders, discusses how the use of derivatives can help address the liquidity concerns.

Many studies indicate that private assets offer a significant risk premium above public market comparators, even allowing for higher asset management costs.

The volatility of private assets is also no worse, or sometimes even better, than the volatility of their public market equivalents. This implies that unconstrained portfolio optimisation would result in very high allocations to private assets.

So why are private assets not more widely used?

Concern over portfolio liquidity tends to explain why private asset allocations are generally well below the theoretical optimum. Indeed, the risk premium on private assets is often explained as an “illiquidity premium”, available only to those who can tolerate illiquidity.

The important point to note here is that liquidity constraints are usually met simply by ensuring that the investor has sufficient liquid assets in stressed downside scenarios to fund their liquidity requirement. In other words, we are not usually stressing the liquidity requirement itself – or the illiquid asset - but instead stressing the residual liquid assets.

However, a stressed event in liquid assets is really just a significant fall in their market value. Thus, the capacity to hold illiquid assets can potentially be increased by managing the downside risk of the liquid assets (i.e. the risk of a significant fall in a liquid asset’s value) and one of the most effective ways of doing this is through the use of derivative instruments.

Derivatives can improve downside risk characteristics of liquid assets

We modelled three different approaches to allocating to private assets subject to a liquidity constraint. The base strategy allocated the maximum amount to private assets that can be achieved without breaching the liquidity constraint in the 99thpercentile modelled outcome for liquidity.

We found that a strategy which allocated an additional 10% to private equity combined with put protection meets the liquidity constraint and still captures two thirds of the improvement in portfolio internal rate of return (IRR) seen in the base strategy, after basically spending the remaining one third of the IRR improvement on the put option protection. 

It is worth remembering that the use of protection serves a dual purpose: not only can it facilitate higher investment in illiquid assets to improve overall expected return, it also reduces the downside risk of the overall portfolio. Indeed, the solution could equally be thought of as subsidising the cost of risk management using the illiquidity premium.

An investor concerned about developed market equity valuations could potentially implement the above put strategy to address downside risk and use an allocation to illiquid assets to mitigate the cost impact on expected return. 

Derivatives can also improve the liquidity characteristics of private assets

Furthermore, the put protection doesn’t have to be notionally paired with the public assets; it can also be paired with the private assets. This strategy can then be viewed as improving its liquidity by providing a targeted “liquidity shot” during periods of public market distress rather than managing downside risk of the private asset per se. 

So, we can view derivative based risk management solutions as either improving downside risk characteristics of liquid assets or improving the liquidity characteristics of private assets.

Derivatives can help increase returns, lower risk and enhance liquidity 

In conclusion, there has been significant interest recently in the idea of combining various forms of private assets to provide blended solutions. We would suggest that derivative based risk management strategies should be considered alongside illiquid assets as part of these blended solutions, potentially creating overall strategies with higher return, lower risk and enhanced liquidity. 

To read the full report as a PDF, click here. To find out more about private assets at Schroders, click here.

This article has first been published on schroders.com.

Three themes for 2019 - and some black swans

Keith Wade, Chief Economist & Strategist at Schroders, discusses three themes that will shape market performance in the coming year, as well as four events that could take investors by surprise.

2018 was a challenging year for investors with US equity and government bond markets both returning less than cash. Two factors were instrumental in delivering this outcome: disappointment with global growth and less cash flowing through the global economy (tighter liquidity).

These factors will continue to influence markets in the year ahead. We have identified three key themes that will prove important for investors in 2019. We also discuss four “black swans” - events which are plausible but not currently being given much weight by markets.

Theme 1. Lower availability of cheap money exposes those reliant on borrowing

In 2019 we expect the volume of money in the global financial system to reduce. The main reason for this is a change in the activities of major central banks. After a period of buying government bonds, the US Federal Reserve (Fed) plans to now sell back some of these investments, withdrawing some cash in circulation. The European Central Bank has said it will stop buying bonds. This leaves the Bank of Japan as the only major central bank still contributing to new money to the financial system (through the purchase of its government bonds).

This matters because when money is easily accessible, and available to borrow cheaply, investors are prepared to take greater risks. In recent years this has helped direct investment into peripheral eurozone markets (e.g. Greece, Portugal, Spain and Italy), some emerging markets and also lower grade corporate credit. As liquidity is withdrawn from the system, an important support for these markets disappears. The early effects of this trend were already being seen in emerging markets in 2018. In 2019 they look set to intensify.   

Theme 2. The return of emerging markets

Given the above discussion it may seem odd but we believe that emerging markets can make a comeback in 2019 – if the US Fed’s policy of interest rate rises comes to a halt. Should this happen - and we forecast one more rate rise in June, taking US rates to 2.50-2.75% - there is good reason to believe the US dollar will lose some of its strength. This would provide a welcome relief to those investors that borrow in dollars –a heavy weight of whom reside in the emerging markets.

The positive effects from this development could more than offset the pressure from the withdrawal of money in the global financial system and escalating trade tensions. Arguably, prices for emerging market assets may already be discounting the worst, with both equities and foreign exchange in those countries having fallen significantly so there is room, following some good news, for a bounce.

Macroeconomic developments will be important as well though and it may need more government spending and/or tax cuts from China before investors’ confidence is more firmly restored. The worry of a US-China trade war remains a looming threat but there is no reason to expect an outright contraction in overall trade as activity should be diverted elsewhere.

Theme 3. Populist pressures mean governments turn to quick fix policies

Without the engine of US or Chinese demand, global growth tends to slow. The US outperformed, in growth terms, in 2018 as a result of President Trump's tax cutting agenda. Other leaders and governments have been taking note. In France, President Macron responded to weekends of riots by meeting populist demands for lower taxes. In the event of a hard exit from the EU, the UK is planning its own fiscal boost. Japan may well be the exception, with an increase in a consumption tax scheduled for October 2019. However, even here measures are being taken to offset the impact.

In any case, the key point is that governments seeking growth are no longer making economic reforms to increase competition or make labour markets more flexible. The approach today is to deliver a quick fix through a tax cut, increased public spending or regulation such as a rise in the minimum wage rate. Some of these measures are warranted and overdue but others are a response by governments to populist pressures.

How are these themes likely to shape market performance in 2019?

Much of the bad news is already priced in by the markets. This of course is no guarantee of positive returns in 2019 but it does mean that markets are better positioned for disappointment and hence potentially more resilient to shocks than they were last year.

Black swans: Thinking the unthinkable

The themes above are reasonably well-known. Black swans are the “unknown unknowns”. By definition, we cannot anticipate them but we have identified four scenarios are plausible. We think they are also worth consideration.

1. Another eurozone crisis

The first eurozone debt crisis began in 2009 and saw several eurozone member states (most notably Greece) become unable to repay (or refinance) their debts. A number of countries were also unable to bail out over-indebted banks. The European Central Bank (ECB) stepped in, effectively printing money to ensure the markets continued to have access to cash, thereby preventing a suspension in activity and possible economic collapse.

Since then, there has been a call, from President Macron in particular, for the creation of a central fund to support growth should such events arise again. This has yet to be formed. A potential new crisis was only narrowly avoided at the end of 2018 when the spending plans of the new populist Italian coalition government tested the strict guidelines of the European Commission. Such drama is likely to play out again in 2019 given the broader rise of populist politics.

2. No Brexit 

This may seem inconceivable given the time and energy currently being poured into sorting a withdrawal agreement. However, “no Brexit” is the only outcome that will not require a vote (apart from "no deal"). As MPs have rejected the current deal on offer, and the EU unlikely to concede anything further, there must be a possibility that the government cancels Article 50 and stays in the EU.

3. Military action 

Sadly, there are plenty of hot spots which could ignite in 2019. The proxy war in the Middle East (being fought in Yemen and Syria) could become an actual war between Saudi Arabia and Iran. China has ambitions for Taiwan and across the region. The recent departure of defence secretary James Mattis indicates a more isolationist US, creating opportunities for others to fill the void. If President Trump’s dismissal of the UN’s function leads to a less co-ordinated international response to territorial skirmishes, Russian ambitions could re-escalate.

4. Trump does not run for re-election in 2020  

Although it is often difficult to read the president's intentions, he appears to be constantly campaigning and setting himself for a second term. However, he will have to see off US Special Counsel Mueller’s investigation into alleged Russian interference in the 2016 election first. Furthermore, he is already the oldest person to be elected president, taking office at the age of 70 and would be 78 if he served a whole second term. Health may be a factor. Or, he could simply decide to do something else: there has been talk of him founding a media empire – Trump TV anyone?

This article has first been published on schroders.com.

Inescapable investment truths for the decade ahead

Charles Prideaux, Global Head of Product and Solutions, and Keith Wade, Chief Economist & Strategist, both Schroders, present their inescapable truths as the economic forces and disruptive forces they think will shape the investment landscape over the years to come.

It seems clear to us that the world investors have got used to over the last few years is very different to the one we need to get accustomed to in the years to come.

We have identified a number of economic forces and disruptive forces we think will shape the investment landscape ahead of us. They represent our "inescapable truths".

Our full paper available at the foot of the page explains these "truths" in more detail through a series of telling charts.

This summary captures the argument.

Economic forces

We believe a confluence of factors will set the scene for a slowing global economy in the next decade:

  • Slower growth in the global labour force
  • Poor productivity growth
  • Ageing populations
  • A growing role for China
  • Low inflation
  • Low interest rates

This backdrop is similar to what we’ve seen since the global financial crisis, where equity and bond markets have performed well despite low growth and inflation. However, the big difference for the years to come is that there will no longer be the tailwind of ultra-loose monetary policy, where interest rates have been kept well below inflation.

As interest rates normalise and quantitative easing (QE) unwinds, we think there will be a greater focus on the reliability of corporate earnings as market volatility increases. Just because GDP growth will be lower, it does not necessarily mean that companies’ profit growth will be lower.

Returns from market indices will also be lower, we believe. Investing passively (tracking a market index) is not likely to reap the returns investors have grown to expect.

The implication is simple: there will be greater need for active fund managers who can generate alpha – i.e. who can beat the market – in the period to come.

Disruptive forces

We think disruption will come from a number of angles in the years to come. 

Market disruption

  • Changing patterns of finance. Banks are likely to play a reduced role in financing economic activity and other forms of funding will grow in importance. We expect the corporate bond market to expand along with private equity and alternatives such as peer-to-peer lending and crowdfunding.
  • The end of QE. Other central banks are likely to follow the US’ lead in gradually reducing the assets on their balance sheets. These were assets bought via QE - a measure to ward off the fallout following the financial crisis. This unwinding will increase the supply of government bonds and corporate bonds to the private sector. It should be welcomed given the present shortage of these supposedly “safe” assets and with more retiring savers seeking investments that may offer greater financial security.

Technological disruption

  • Changing business models. Technology creates unique challenges for investors through its tendency to disrupt existing businesses and create winners and losers. Clearly picking those who are on the right side of technological progress will continue to be key for investment performance.
  • Displacement of jobs. Technology can bring greater efficiency in production, but can also increase displacement in the labour market as traditional jobs become obsolete. The increased use of robotics and AI (artificial intelligence) will affect a wider range of professions. This may worsen the problems of inequality and potentially bring even greater political disruption.

Environmental disruption

  • Rapid action needed. Our views of the future are complicated by growing tensions between the real economy and the natural environment - and climate change in particular. The challenge has been centuries in the making, but remedial action will have to be far faster to avoid its worst impacts.
  • Unchecked environmental damage will have severe economic and social consequences. While inaction implies significant long-term risks, steps to avoid the worst effects of climate change will also prove necessarily disruptive.

Political disruption

  • Government finances will come under pressure. The economic outlook will undermine government finances, while ageing populations will increase pension spending and demand for healthcare. The ability of governments to meet voter expectations will become increasingly challenged and may feed further populist unrest.
  • Pressure on individuals will grow. Government challenges will mean people will have to take greater individual responsibility for funding their retirement and healthcare.
  • The rise of populism will increase political complexity. Policies to temper the impact of globalisation through restrictions on trade, immigration and capital flows are increasingly likely to emerge.

In summary, after almost a decade of strong returns many investors have become complacent about the outlook. This assessment suggests that in a more challenging future environment factors such as asset allocation, access to multiple sources of return, active stock selection and risk management will be critical in meeting the goals of investors over the next decade.

As we enter the next phase of the post-global financial crisis era, these inescapable truths can help guide investors through a time of unprecedented disruption.

Please click on the link to download the full report as a PDF.

This article has first been published on schroders.com.

Are short sellers ethical?

It’s a few of the practitioners, rather than the practice, of short selling that can be unethical, argues Duncan Lamont, Head of Research and Analytics at Schroders.

On the face of it, an investment strategy specifically designed to gain in value when companies fall in value might not seem particularly responsible. So-called “short selling” is often associated with lurid headlines predicting corporate failure, market abuse and policymakers’ concerns that the practice undermines financial markets. However, a look past the headlines reveals a more complex reality.

While it undeniably has its more unsavoury side, short-selling can also help manage risk more effectively and contribute to market efficiency. Its reputation is unfairly tarnished by the actions of a few cowboys.

What is short selling?

So, cutting through the jargon, what do we actually mean by short selling? In practical terms, it involves borrowing a stock from an investor then immediately selling it, in the hope that its price will fall and it can be bought back later at a cheaper price. A profit is realised based on the price decline. At that stage it is returned to the original shareholder, who receives a fee for their troubles.

The borrowing involved in this strategy introduces some additional risks (and costs) compared with traditional stock market investing. One implication is that positions tend to only be put in place for relatively short time horizons. Another way to profit from declines is through derivatives known as futures, although these are more commonly used at the overall stock market level than for individual stocks. A so-called “short futures” position will deliver a return if a stock market falls and a loss if it rises.

There are no blanket answers to questions of the ethics of short selling. In our view, the pertinent question is less whether short selling is ethical and more how investors behave, whether in expectation of price rises or falls.

Short selling does not directly undermine the health of a company any more than buying its shares improves its fundamentals. Companies are not deprived of funds when investors sell shares nor do they become financially stronger when investors buy shares in public markets.

Ethical questions arise when investors take additional steps to influence companies’ financial health and value after they have bought or sold shares. To assess the ethics of short selling, we therefore need to consider the actions of different short sellers rather than short selling as a principle. In general, those actions reflect their motivations, which can be broadly split into four categories:

Stock picking on steroids

Traditional so-called long-only investors in the stock market try to identify undervalued stocks, in the expectation that their value will converge on some estimate of fair value. If they don’t like a company they can hold less of it than the benchmark allocation (an underweight position) or not hold any at all.

The stock picker on steroids is no different but they search for overvalued stocks or stocks which are facing structural headwinds that are not yet fully reflected in the price. “Shorting” these companies is a more direct way to position for their anticipated fall in value towards more reasonable levels than would be possible in a long-only portfolio. This can either be done on a stand-alone basis or by taking a long position in (buying) those companies that are expected to do well and a short position in those that are expected to struggle. It’s like the value style of investing but with extra bells on top.

Stock pickers on steroids also help to bring market prices into balance, so contribute to overall market efficiency. This beneficial impact is one reason why the index provider MSCI requires short selling be possible before it will consider a market for inclusion in its developed market benchmarks.

An area of emerging interest is funds with a sustainability focus which short stocks. Some investors prefer to exclude certain sectors from their portfolios such as tobacco stocks, oil and gas companies, and weapons manufacturers. However, a more extreme approach would be to take an outright short position in these sectors, or in companies with poor (or deteriorating) sustainability credentials more generally.

To manage risk, shares in companies or sectors with more favourable (or improving) characteristics could be bought. That would send a very strong signal to the management of the companies being shorted and would earn a profit if their share prices fell relative to those with better (or improving) credentials.

The activist shorter

The activist shorter takes a more extreme approach than the stock picker on steroids. Rather than assuming that the market will eventually price companies fairly, they seek to force the issue.

They often try to maximise publicity on their reasons for believing a company is overvalued. By generating negative coverage they can force a company’s share price down, which can affect the terms that a business can get from its creditors, which can push the company into further difficulty. On one level, this can be applauded. The forensic analysis conducted by some short sellers can unearth previously underappreciated issues (accounting irregularities are a common target) and in making these public, they can force management to deal with them.

However, the more extreme activist shorters are the ones that give the practice a bad name. Some have been guilty of spreading unfounded and malicious rumours in the press, a consequence of which is that they can earn a profit on their trade but push otherwise healthy companies into financial difficulties. Even if these companies manage to prove the accusations false, the short seller may be long gone by that stage, having booked a profit on their trade and left a trail of devastation in their wake.

The concerns are comparable to investors buying long positions in shares before attempting to boost the value of their holdings by spreading dubious suggestions of coming positive news.

Before investing in strategies which take a more activist approach to shorting, investors should ensure they understand the process and tactics that are likely to be employed and, to the extent it is possible, the integrity and ethics of the fund manager.

The risk manager

These people use shorting to control risk in their portfolios and express their views on particular stocks in as pure a way as possible. Let’s say an investor wants to express a positive view on a particular stock relative to the market. One way to do this would be to buy the stock. However, then, if the market falls, that stock could fall too. If it falls by less than the market the original thesis would be proven correct but that would have been somewhat irrelevant as it would have been swamped by the decline in the broader market.

One way to avoid this is to buy the stock while also taking out a short futures position on the market. Then the return would be the difference in return for the individual stock and the market. In our example above, the trade could yield a profit, even in a declining equity market. Shorting allows a cleaner expression of a view on a particular stock or sector while also reducing volatility and risk of loss. The approach does not affect the health of individual companies, is typically low profile and doesn’t raise ethical concerns in our view.

The emotionally-detached trend follower

The trend follower seeks to profit from trends in markets; buying when markets are rising and shorting when they are falling. CTAs (Commodity Trading Advisors, although the name is a misnomer as although they were once focused on commodities, they now cover a much wider range of asset classes and currencies) or managed futures are other names for these types of investment strategy.

These strategies are normally highly quantitative and systematic in nature, powered by powerful computer algorithms. Their emotionally detached nature means they cannot be accused of attempting to drive down prices. It is all about maths.

An unfair reputation

In summary, short selling has an unfairly bad reputation. Rather than avoiding the practice, investors, especially those who are more ethically minded, should ensure they understand its potential uses in a strategy and how its practitioners intend to behave. It can bring about significant benefits, both to investment performance and standards of corporate governance. Some short sellers are unethical, but short selling itself is not.

This article has first been published on schroders.com.

Where’s the value in value investing?

The past decade has been marked by several unique features that have turned the value style of investing on its head. Sean Markowicz, Strategist at Schroders, explains why this abnormal trend may be coming to an end.

Value investing has a long and illustrious history, championed by none other than Benjamin Graham, the man who arguably invented scientific stock analysis in the 1930s.

The premise is simple: investors tend to overpay for stocks with good news to tell – like growth stocks – and underpay for those with bad – like value stocks. Eventually, though, profits return to their long-term average and the mispricing corrects itself, bringing gains to contrarian investors who have defied conventional wisdom and bought value stocks that have been unfairly marked down.

As well as the value of investments going up and down, it is important to note that investors may not get back the amounts originally invested when investing.

The problem is that, since the Global Financial Crisis (GFC), value stocks have endured their worst period of underperformance on record. The normal bounce-back for value just hasn’t happened. So does this “lost decade” mean there has been a permanent shift away from value?

Probably not. For a start, it looks like an anomaly. One measurement of performance developed by two leading academics, Eugene Fama and Kenneth French (see chart), suggests there have been only three significant periods of underperformance for value in the last 90 years: the Great Depression of the 1930s, the Technology Bubble of the 1990s and the post-GFC period of the last 10 years. But the length and depth of the most recent episode is the most extreme on record.

Value has nearly always outperformed growth – until recently

Source: Kenneth French’s Data Library and Schroders. Data from July 1926 to December 2017.
Past performance is not a guide to future performance and may not be repeated.

The last 10 years have been marked by several unique features that have turned value on its head. The most notable has been a prolonged period of slow economic growth following the GFC and accompanying aggressive central bank intervention.

This highly unusual period has radically altered the environment for value stocks. For instance, the abnormally slow recovery in the aftermath of the GFC has meant that the normal “sweet spot” for value, when company earnings rebound after an economic downturn, has been insipid to say the least this time round.

The relative scarcity of earnings growth has also magnified investors’ interest in growth stocks, which are perceived to offer more earnings certainty. This trend has been focused in a handful of tech companies, notably the so-called “FAANG” stocks - Facebook, Apple, Amazon, Netflix and Google (Alphabet). In contrast, value stocks, whose earnings are generally more exposed to economic downturns, have been shunned.

Aggressive central bank intervention has not helped either. This has had the effect of reducing interest rates to historic lows, which has tended to favour growth stocks. Their profits, seen as stretching out into the distant future, are more highly valued by the stock market in these circumstances than when rates are high. Falling interest rates have therefore benefited them far more than value stocks in the recent economic environment.

The combination of minimal growth and low interest rates has fuelled an astounding volume of share buybacks. Since value stocks are typically more cyclical businesses, they tend to have less capacity to return cash to shareholders during bad economic times than growth stocks. In the current economic climate, this has placed value stocks at a significant disadvantage at a time when investors have valued share buybacks.

However, many of these headwinds for value are dying down or reversing. Economic growth is finally picking up, interest rates are rising and buyback activity seems to have peaked.Although nothing is guaranteed, a market rotation in favour of value seems increasingly likely over the coming years.

Furthermore, the valuation difference between value and growth stocks is at its widest level in many years. In the past, differences of this magnitude have heralded significant value outperformance over subsequent years, although past performance is not a guide to future performance.

So big is this gap that our calculations suggest that long-term interest rates would have to fall to zero over the next decade for growth returns to merely equal those from value. If you believe that this scenario is highly unlikely, then betting against value may no longer look like a winning trade.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

The full report targetting professional investors and advisers only is available as a PDF on Schroders.com.

This article has first been published on schroders.com.

How will climate change impact your investments?

Climate change is no longer something to think about for the future, it is something for investors to consider right now. 

Last week a panel of specialists gathered at Schroders to discuss why climate change is an increasingly important topic for investors. The panel consisted of:

  • Andy Howard, Head of Sustainable Research, Schroders
  • Jillian Reid, Principal, Responsible Investment, Mercer
  • Thomas Fabricius, Senior ESG and Equity Analyst, Danske Bank
  • Simon Webber, Fund Manager, Schroders

Please find a recording of the panel discussion on schroders.com.

A future issue has become a “now” issue

Andy Howard, Head of Sustainable Research, Schroders:

“Climate change is not a new issue; the science behind it and solutions to it really haven't changed that much over the last 10 years. But what's changing now is that we're beginning to see some of those points start to shift from being potential future questions to things that are really beginning to change.

“Whether it’s the regulation we’ve seen on diesel cars or on carbon pricing, or the dramatically-improved economics of clean energy, we're at a very interesting point for climate change and it’s clear it will be a critical issue going forward.”

Has a 4°C rise in temperature been avoided? 

Jillian Reid, Principal, Responsible Investment, Mercer:

“We’ve come a long way since we at Mercer published our report “Investing in a time of climate change” in June 2015.

“We're now in a post-Paris Agreement environment, and it’s now looking very possible that a rise of 4 degrees Celsius will be avoided. We’re more likely to be able to stay below a 3 degree rise. In our original study we debated whether a 2 degree scenario should even be included, whereas now there is optimism that it’s possible.

“The conversation has certainly shifted. I almost never have to have that conversation about whether you believe in climate change anymore, but I think there is still an underestimation of the physical risks.”

Andy Howard, Head of Sustainable Research, Schroders:

“When you look at all the different things going on – whether that’s clean energy investment, oil and gas production, politicians’ statements, or the price of carbon – they can all paint very different pictures. So we’ve built the Schroders Climate Progress Dashboard, to try to make sense of this very complex situation.”

“By putting all of these factors together in one place we get a sense of the way the world is heading. It's currently not a particularly optimistic picture. The outlook is still closer to a rise of four degrees than two degrees, but it is starting to move down towards the two-degree mark.

“So, we think our dashboard is telling us there is still a long way to go. We're moving in the right direction incrementally. But there is a big gap between the level of change and disruption that we're seeing at the moment, and the level that we will need to re-engineer the global economy effectively from fossil fuels, which currently provide 80% of our power, to a more renewable and sustainable form of economic growth.”

What does all this mean for active fund managers?

Simon Webber, Fund Manager, Schroders:

“As an active investor, this whole issue and area is incredibly interesting and powerful, because the markets are very good at assimilating short-term information and very bad at long timeframes and discontinuities.

“If we’re going to get to the middle of this century with a 70% to 90% cut in greenhouse gas emissions, it is a complete transformation in the architecture of our energy industry, as well as automotive transportation, agriculture, heavy industry and chemicals and numerous other sectors.

“As investors we need to be thinking through how these industries may change in structure: which companies are positioned for that, which are not.

"Some companies will just focus on maximising their short-term profits. They won’t think about investing for five to ten years down the line, whether that’s so they have a license to operate, or whether it’s for technology that their customers are going to want. These short-sighted companies will see their business start to shrink.

“For active managers, there is a wealth of opportunity for us from being part of that solution. In my experience, having run a climate change-focused strategy for 10 years now, I am constantly amazed at how markets, investors, analysts, and company management teams struggle with the scope of the change that is likely coming. Therefore, there is a big role for investors and active managers to support those companies that can help us move in the right direction.”

This article has first been published on schroders.com.

Why are investors so optimistic about returns?

With returns likely to be lower in future than they were in the past, investors may need to re-set their expectations or accept higher risks, says Emma Stevenson, Investment Writer at Schroders.

The Global Investor Study carried out by Schroders in 2017 found that investors’ expectations of returns are high. More than a third were looking for a return of 5-9% per annum, over the next five years, while 31% expected 10-19%.

Those investors looking for income have similarly high targets, with our 2016 study finding that 41% of investors were looking for income of at least 8% a year.

With interest rates still at low levels ten years after the global financial crisis, it may seem surprising that investors have not adjusted their expectations downwards. If anything, the opposite has happened, with our study finding that milliennials have the most optimistic return expectations of any age group.

However, a typical trait of human beings is that we take the experience of the past and extrapolate it into the future. That is, we largely expect the future to be much the same as the recent past. And, when it comes to investing, the recent past was an era of high returns.

High returns not such a distant memory

The chart below shows annualised real returns (i.e. adjusted for inflation) for both equities and bonds, as experienced by the baby boomer generation (those born between 1946 and 1964) and Generation X (1964-1980).

The point about real returns is an important one here, given high inflation was experienced during the period, particularly in the late 1970s and early 1980s. The charts show equity returns have been fairly high across every region, and bond returns particularly strong since 1980. 

Chart showing historic returns have been high

Past performance is not a guide to future performance and may not be repeated.

The future may well be different

However, most forecasts suggest that future returns will be well below these levels. There are several reasons for this. Firstly, inflation is expected to remain low, albeit rising from recent ultra-subdued levels. Low inflation means a smaller yield premium is demanded by bond investors to compensate for the erosion of buying power inflicted by inflation.

Secondly, low inflation also implies low interest rates. Although on the rise from crisis levels, interest rates are widely expected to remain fairly low because global economic growth is forecast to be slower in future than in the post-World War Two era. Again this is due to numerous factors, including moderating expansion in some emerging economies, and demographic changes such as a slowdown in the growth of the working age population.

As a result of these and other factors, returns are expected to be lower in the future.

Lower returns expected on seven- and 30-year view

The chart below compares the high historic returns with the latest long-run returns predicted by the Schroders Economics Group. These indicate that the 6%-plus equity market returns enjoyed in the recent past are not expected to be reached in the US, UK or Europe. It is an even starker picture for bonds, with negative real returns expected in the UK and Europe on a seven-year view. 

Chart showing future returns are forecast to be lower

Not shown on the chart, Schroders Economics Group forecasts Asian equities to outperform most developed equity markets on a 30-year horizon, as a consequence of differences in productivity growth. Even here though, real returns are forecast at 5.4% for the Pacific (excluding Japan) region and 5.9% for emerging markets.

Higher returns still possible, but with higher risk

What does this mean for investors? With interest rates looking set to stay low, cash savings will be eroded by inflation. Investors seeking higher returns may need to save more and/or broaden the asset classes they invest in.

This brings other risks, for example investors in higher-dividend paying equities will need to be mindful of the price they pay for those stocks. Credit (corporate debt) is another option but higher-yielding issuers often carry higher risk of default.

Income-seekers may need to invest over longer timeframes, and keep currency risk in mind if they invest outside their home region.

As a result, investors looking for higher returns and income may need to turn to asset managers for help in achieving their aims while mitigating these risks.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.

This article has first been published on schroders.com.

What has driven stockmarket returns and what will drive them in future?

While the equity markets of various countries and regions have performed very similarly over the past three years, the components of returns have been very different, shows Duncan Lamont, Head of Research and Analytics at Schroders.

When we look back over the past three years, investors have earned remarkably similar returns in local currency terms in very different parts of the world.

UK, eurozone, Japanese and emerging market equities have all returned close to 9.5% a year1. The US, as is well known, has been the outlier and star performer, delivering closer to 11.5% a year.

However, when we look behind the numbers at what has been driving that performance, we find an altogether different and more diverse set of circumstances. The chart below decomposes returns over the 2015-2017 period into their key components:

  • Income (blue bar) – dividends2
  • Earnings (green bar) – how fast have companies grown their earnings?
  • Valuations (red bar) – how has price/earnings multiple changed? Does the market now value companies more or less, for a given level of earnings

The sum of these components approximates the return on the stockmarket, which is shown with a black diamond.

Past performance is not a guide to future performance and may not be repeated. 

Three key features stand out:

  • US returns have been driven predominantly by increasing valuations. Earnings growth has been next to nothing.
  • Japanese and eurozone equities have been powered by a combination of strong earnings growth and dividends. The market has failed to reflect these better fundamentals in valuations, which have stagnated.
  • UK equities have had a rollercoaster ride. The decline in commodity prices contributed to a collapse in earnings over the past three years, given the market has a large allocation to this sector. However, investors have been prepared to value companies higher relative to those depressed earnings, which has softened the blow. One explanation for this is that investors have priced in a sustained recovery in commodity prices.

When we look at 2017 in isolation we find a different set of drivers. Synchronised and strong earnings growth everywhere has been the main engine of returns in all markets.

So, as investors, what should we make of this? Firstly, the fact that US returns have been so poorly underpinned by fundamentals is a concern. Stellar returns have been built on shaky foundations. This can only go so far but reassuringly, 2017 saw strong earnings growth in the US and 2018 is also shaping up for more of the same. The necessary rebalancing in the drivers of returns is underway, which suggests the rally may yet have legs.

Unloved markets

Elsewhere, it pays to have an eye on those markets that have been somewhat unloved. Despite generating the strongest earnings growth of all markets shown, the valuations of Japanese equities have languished relative to the rest of the world. They are lower at the end of 2017 than a decade earlier. After decades of poor growth, investors have remained somewhat untrusting of the recovery. Should this hold out, then there is more potential here than just about anywhere else for increasing valuations to boost returns.

European equities have also not been hugely rewarded for the earnings recovery that has commenced. Valuations have hardly changed since 2013. Given their earlier stage of the economic cycle, earnings growth is likely to drive returns in 2018 with potential support from valuations.

The UK equity market has been the worst place to be invested from an earnings standpoint. Earnings rebounded sharply in 2017 but remain over 40% lower than their 2007 peak and even 30% lower than after their mini recovery which fizzled out in 2011.

A chunky dividend yield of close to 4% provides a solid base for returns but unless earnings recover, this is unlikely to be sustainable. UK companies paid out 80% of their earnings in 2017 to cover dividends, way above the long-term average of around 50%. Commodity prices have rebounded and both dividends and earnings have a lot riding on that holding out.

The drivers of emerging market equity returns have been reasonably well balanced over the past three years. Valuations have risen but are not as extended as in some other markets and earnings stand to benefit from the synchronised global recovery and weakness in the US dollar. The potential for positive contributions from all factors remains on the cards in 2018.

Earnings growth – a positive driver

At a very high level, the supportive economic backdrop suggests that earnings growth should positively contribute to all markets in 2018.

Dividends are also well supported in all markets other than the UK, which is beholden to commodity prices.

The big differences could arise from valuations. No market is immune to falling valuations but that does not mean returns have to be negative, if the other two drivers contribute enough. A year of solid, if not spectacular, returns could be on the cards.

1) Emerging market equities represent a basket of different currencies. Local currency for emerging markets has been taken to be USD.
2) Technically, the income return has been calculated as the difference between the change in the share price and the total return earned on an investment

This article has first been published on schroders.com.

How investors can profit from urbanisation

Europe’s renewed urbanisation and accompanying infrastructure upgrades provide interesting opportunities for real estate investors, says Oliver Kummerfeldt, European Real Estate Analyst at Schroders.

When we think about urbanisation, we often conjure images of newly constructed skyscrapers in Asia or rapidly-growing cities in South America or Africa. Indeed, the proportion of the world’s population living in towns and cities is forecast to increase from just over half today to two thirds by 2050 (source United Nations).

Most of this urbanisation is occurring in Africa and Asia, as people raise their living standards by moving from subsistence agriculture to paid employment in manufacturing and services in city locations.

The current process of renewed urbanisation in Europe is an exciting phenomenon which will impact us all and which sits at the heart of our investment philosophy to focus on “winning cities”.  

Urban renaissance

While Europe’s cities have experienced phases of rapid urbanisation since the industrial revolution in the 18th & 19th centuries, the 70s and 80s saw many people leaving cities to escape congestion, pollution and crime. In recent years, this trend has reversed. The “spatial segregation” of "work, life and play" that prevailed in the 70s and 80s is reversing fast.

Increasing numbers are keen to live in central locations where work, life and play coexist. The UN is estimating that urbanisation in Europe will rise from c. 80% now to c. 87% by 2050. While 7% might not sound much, this represents another 35 million people; four additional cities the size of London.

This creates a huge amount of demand for real estate, and opportunities for investors to develop, reposition or refurbish assets - or adapt their current use - in exciting growth locations. 

However, the population shift to cities also presents a challenge. Development land is scarce in central locations. Providing additional commercial space, homes, schools, hospitals and transport infrastructure is complex and costly. A number of cities in Europe are responding positively to this, providing real opportunities for real estate investors that are able to identify the winning locations.

New lease of life

A major part of urban restructuring has involved former industrial zones, docks and ship yards.

Whilst London Docklands might be one of the earliest examples of this, a number of Nordic cities have witnessed a similar process. Examples include Fjord City in Oslo, the Osterport/Nordhavn area in Copenhagen, the Kalasatama and Western Harbour in Helsinki, the Royal Sea Port in Stockholm and River City in Gothenburg.

The re-use of these areas to create new, mixed-use urban areas fulfils an important role for these cities, not least as some have amongst the fastest growing populations in Europe. Other examples further south include Hamburg’s HafenCity, Rotterdam’s Kop van Zuid, Amsterdam’s IJ-oevers or Marseille’s Euroméditerranée.

What all of these examples have in common are attractive waterfront locations in central locations. Each offers the potential to create areas with a good quality of life and a range of uses, including offices, retail, residential, leisure and public services.

These inner city areas are of particular importance as many governments have taken a tough stance on greenfield developments on the edge of cities. The European Environment Agency has seen cities expanding by 78% in area in the last 50 years, whereas the population has grown by only 33%. Modern policies are hence focused on increasing densities.

Gentrification is a key feature of such regeneration. Former working-class neighbourhoods are being transformed into more affluent areas. Berlin’s Kreuzberg, Prenzlauer Berg or Friedrichshain areas or London’s Bermondsey, Shoreditch or Bethnal Green are amongst the most prominent examples.

“A great city is not to be confounded with a populous one.” 

Of course, urbanisation also puts pressure on infrastructure. As a result, Europe’s cities are seeing a wave of investment into transport infrastructure; both new and existing. Traffic congestion and pollution has a measurable, negative impact on economic growth and well-being. Sustainable and smart mobility is hence a key element of managing further growth.

The majority of infrastructure projects underway principally revolve around increasing mass public transport, predominantly by rail. The largest project by far is the “Grand Paris” project in Greater Paris / Ile-de-France. This will be developed in phases, and upon completion in 2030 will provide over 200km of new track and almost 70 new stations.

The key objective of the project is to connect the various neighbourhoods around Paris directly by rail, ease congestion and better connect central Paris and the suburbs. Real estate investors - including ourselves - are responding to this by investing around the new transport hubs and those areas with greatest growth potential.

No less ambitious is London’s Crossrail, which – in contrast to some other projects – is on track in terms of timing and budget. The new line will run from as far west as Reading to Shenfield in the east and will provide c. 10% additional capacity to public transport in London.

The new North-South metro line in Amsterdam will also have a transformational effect. The areas on the northern bank of the Ij-river at the moment depend very much on ferries and the road tunnels. It is little short of an engineering masterpiece considering the challenges of constructing anything underground in soil conditions such as those found in Amsterdam. The new line will connect the “Station Zuid” at the centre of Amsterdam’s “Zuidas” central business district via the city centre with the northern bank.

The western extension of the Helsinki metro is scheduled for autumn this year. This will provide improved access to the city centre for affluent western suburbs as well as improving access to Aalto University and the Keilaniemi neighbourhood; a popular office submarket with technology and engineering companies. The planners are not stopping there. Having successfully completed rail access to Vantaa airport in 2015 (the “Ring Line”), there are now plans for further light-rail services (“Jokeriline”) and extensions to the tram network as well as a potential rail loop under the city centre.

Elsewhere, cities like Brussels, Barcelona, Stockholm and Copenhagen are also extending their existing metro networks. In Luxembourg, a new tram will hopefully ease road congestion by commuters travelling from the suburbs and neighbouring Germany, France and Belgium by car.

Stay selective

Understanding the changes to Europe’s cities and the city landscape are fundamental for real estate investors. Cities are the centres of economic activity and innovation, and grow much faster then the wider economy. As such, we continue to focus our investment approach on cities, not countries.

Further urbanisation will increase the demand and competition for space. New transport infrastructure will see city geographies change and new submarkets emerge. There is a strong inverse correlation between transport costs and real estate values. This provides opportunity for investors that can anticipate the changes and commit to locations with the right ingredients for long-term growth.

This is the age of the city.

This article has first been published on schroders.com.

The acid test of active management

Active managers are more likely to outperform in certain market conditions, but our research finds that there is also a group that can outperform whatever the weather. Clement Yong, Strategist, Research and Analytics, at Schroders, on “good” asset managers.

All sailors know that there are environmental conditions that affect their performance, notably wind speed and direction, currents and tides. When conditions are ideal, even average sailors tend to do well, as the favourable conditions carry them along. However, when conditions are challenging, only more skilful sailors will be able to outperform.

In the same way, we have found that active managers add more value in particular market environments than others and only truly skilled managers are able to navigate through more challenging waters. Our research suggests that the two key variables that determine these environments are the extent to which share prices tend to move together (known as “correlation”) and, the distance those prices typically travel relative to each other (known as “dispersion”). This makes sense as it should be much easier to distinguish winning stocks from losing ones when the market’s correlation is low and, once a winning stock has been distinguished, the returns for the holder of those stocks should be that much greater if dispersion is high.

We found this theory borne out in practice when we looked at historical records: when market correlations have been low and dispersion of returns high, active managers have performed the best (see first circled bar in chart below). On the other hand, active managers have performed worst when correlation and dispersion were both high (see second circled bar). This environment mostly occurred during the depths of crises, suggesting the average active manager  possesses insufficient skill to weed out underperformers when all stocks are falling together. Currently, however, conditions have turned favourable for them as correlation continues to stay low.

Average UK managers' monthly excess returns

The picture changes significantly when we analyse the outperformance of “good” managers1 in the various environments. The main conclusion we reached was that they tend to perform well in all environments. Good managers still do best in the low correlation, high dispersion environment but, contrary to the experience of average managers, they do least well in a high correlation, low dispersion world. This is arguably when their stock selection skills are least effective as the difference in returns between winners and losers is minimal. Contrary to the average manager, the “good” manager does much better in the high correlation, high dispersion environment. This may be because good active managers have enough skill to avoid the worst performers when all prices are falling.

Average UK managers' monthly excess returns

It is worth noting that, although what we have discussed applies to the UK market, the pattern of returns and conclusions are virtually identical for the Japanese market, emerging markets and even those in the US, where active performance has been much maligned.

Our definition of “good” managers so far has been rather like a football league: they are not a fixed group but come and go as their performance promotes them or relegates them to or from the top tier over the period investigated. However, a more practical question is whether it is possible to find a group of active managers who consistently outperform in different environments. We believe it is, and that the knowledge of how managers have performed in different environments in the past can be used as a guide to selecting active managers who are well placed to consistently perform in the future.

To show this, we looked at UK funds that have been able to deliver the most consistent  outperformance during both favourable and challenging environments. In each case, we identified the 100 funds that most frequently outperformed. We then looked at how much overlap there was between these lists, i.e. how many of the 100 funds that most persistently outperformed in the favourable environment also featured in the top 100 for the challenging environment. 32 funds passed this test. This suggests that there is a group of skilful fund managers that has been able to persistently outperform its benchmarks in both favourable and challenging conditions.

Why is this important? Because these truly are managers who consistently perform. For instance, we found that these 32 “persistent” managers were able to outperform in consecutive periods more frequently than the average manager. Not only that, the 32 also had a lower chance of consecutiveunderperformance than other managers.

We don’t want to minimise the difficulties facing investors in identifying good. Our research confirms that when looking at past performance, it is vital to contextualise the performance of those managers in both favourable and challenging environments to gain a true picture. And for anyone who feels they have the skill and expertise to do that, the current environment looks favourable for those few active managers who consistently shine.

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

1) We define the “average” active manager by calculating the average outperformance achieved by all actively managed funds (including those that have failed to survive over time). We define “good” active managers as those able to achieve the top 25% of returns. This theoretical approach would not necessarily reflect the experience an individual investor would have experienced.

This article has first been published on schroders.com.

The case for active asset management

The debate on whether to use passive or actively-managed funds can sometimes be one-sided. Our research suggests investors should keep an open mind, says Gavin Ralston, Head of Official Institutions and Thought Leadership at Schroders.

Investors seem to be voting with their feet. The scale of the recent shift of money from actively managed funds into those that track market indices has become hard to ignore.

According to data from specialist information provider analyst Broadridge, nearly $2.4 trillion has flowed into passive exchange-traded funds (ETFs) in the US over the last 15 years, while $500 billion has moved out of active funds.

This trend is held up by many commentators as decisive proof of investors’ belief in the superiority of passive investing over the skills of a fund manager. But seemingly unstoppable investment trends have a habit of reversing unexpectedly.

We argue that, before rushing to conclusions, investors should take a long hard look at both the data and what so-called “passive” funds actively offer.

Ultimately, we think both have a place in portfolios, but it’s in the interests of investors to strike a balance between the two and use each method when and where it is most appropriate. The research we have undertaken recently certainly suggests that investors should keep an open mind.

A Sharpe definition of active management

The classic academic view of active management was proposed by Professor William Sharpe, who argued that, “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”.

In reaching this conclusion, he assumed that the index represented the entire range of investment opportunities, and that all participants were motivated by the same objectives.

In truth, for many investors, an index return may not coincide with the outcomes they are seeking. For instance pensioners needing to create a secure income in retirement.

Since Sharpe, many researchers have demonstrated that markets are less efficient than once thought, and that investors’ behavioural biases and irrational decisions create opportunities for active managers.

Markets have also become distorted by the actions of central banks, buying bonds in quantitative easing programmes, or by governments owning stakes in companies.

Some markets are more efficient than others, but conclusions are often transferred from one to another. We have analysed the data on different markets.

How data is used in the active/passive debate

Data from SPIVA, part of S&P Dow Jones Indices, is often used in the passive-active debate. A recent SPIVA (S&P indices versus active) report stated that over 88% of large cap equity funds in the US underperformed the S&P 500 Index in the latest five-year period.

In the case of large cap US equities, this conclusion is reinforced from other sources, but there are weaknesses in the SPIVA methodology.

It assumes any fund which has closed or been merged into another fund has underperformed. This assumption is not universally valid. We tested UK stockmarket funds that had closed in the past 10 years and found that 20% had outperformed before closure.

SPIVA also picks its own S&P index for each fund comparison rather than the actual index a fund has set out to beat.There is a tendency to extrapolate from the US market the conclusion that other equity markets are hard to beat.

But the US is different – institutional ownership, particularly by home-grown institutions which are more familiar with domestic securities, is significantly higher than in other countries. The US, therefore, is a more efficient market.

We looked at performance in other major markets. But rather than assume passive performance is the same as the market index, we have used a more realistic comparison – ETFs.

These bear real management fees and trading costs, which an index does not. The results, below, suggest that in many markets the argument that most active funds underperform is far from clear cut.

A realistic reflection of investors’ experience shows active in a better light.

ETF cumulative returns vs. benchmark five years to 31 March 2017

Returns are shown in US dollars except for UK equities in sterling. Includes actual performance of funds closed and opened during the period. Source: UK equities - iShares Core FTSE 100 UCITS ETF; Emerging market equities - iShares MSCI Emerging Markets ETF; Eurozone equities - iShares MSCI Eurozone ETF; Japanese equities - iShares MSCI Japan ETF; Global bonds - Vanguard Global Bond Index fund (Institutional hedged – US dollars); US high yield - SPDR® Bloomberg Barclays High Yield Bond ETF; Emerging market bonds - iShares J.P. Morgan USD Emerging Markets Bond ETF. Past performance is not a guide to future performance and may not be repeated.

Drilling down further, we looked at how active performance has varied over time in the UK and emerging markets. We looked at monthly excess returns after fees – in this case against the index.

Unlike previous studies, we included only funds that are benchmarked to a broad index. By doing so, we excluded the funds that are either not benchmarked, or funds that employ a specific strategy, such as sustainability or special situations.

The charts below show the percentage of active funds in the UK and within emerging markets that have outperformed their benchmarks on a rolling five-year basis. Only funds that have a full five years of performance history at a given date were included in the calculation.

Data from the UK shows that the performance of active managers is cyclical, but that there have been several periods, including the present, when well over 60% of active funds have outperformed net of fees.

The second chart shows a similar pattern for emerging markets equities, with active performance improving steadily since 2008.

Active performance has improved in the UK…

UK percentage of funds outperforming (rolling five years)

Investment Association primary retail share class active UK equity funds domiciled in the UK in sterling. Source: Morningstar. Data to March 2017. Past performance is not a guide to future performance and may not be repeated.

…and among active emerging markets funds

Percentage of emerging markets funds outperforming (rolling 5 years)

Active EM equity funds domiciled in the US denominated in US dollars; retail share class with longest history. Source: Morningstar. Data to March 2017. Past performance is not a guide to future performance and may not be repeated.

There is also good evidence that managers who perform well over the longer term experience significant periods of underperformance in the short term.

The Vanguard Group published a study in 2015 which showed that, of the 552 active US equity funds that had beaten the index over the previous 15 years, 98% had underperformed in four or more individual years.

The implication is that investors are more likely to achieve good outcomes if they do not abandon a strategy after a short period of underperformance.

Another important consideration when considering passive investing is fees. We measured active performance against indices net of fees, which penalises performance as the index bears no costs.

Assuming a 0.30% average annual passive fee for UK equities over a 26-year period, the passive fund would have trailed the benchmark by 8%. So while many active funds may have underperformed the index, 100% of passive funds have underperformed.

The point about measuring the real cost of passive management is most visible in emerging markets, where the costs of acquiring market exposure have been higher (until recently typically 0.75%) than in developed markets.

Of course, the cost of passive has fallen significantly in the last few years, raising the standard against which active managers will be measured in future, but in many markets passive costs are still material.

The advantages of active in bond investing

A passive bond fund tends to allocate money based on the amount of debt issued.

In the case of a government bond fund, this could result in investors being directed towards governments with debt problems. In developed markets, this could mean investing large amounts in Italian bonds; in emerging markets, Venezuelan bonds. There is little logic to this approach.

In addition, new securities, which typically make up 20% of bond market capitalisation in a year, have to be included in bond market indices. This is far higher than in stockmarkets and will inevitably raise trading costs. As a result, passive bond funds can significantly underperform their indices, as the table below demonstrates.

Two large bond ETFs have consistently underperformed their indices.

The two large bond ETFs that have underperformed

Chart shows annualised returns in US dollars to 30 April 2017, net of fees. The Bloomberg Barclays High Yield Very Liquid Index is the benchmark for the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). The Global Core Index is the EMB fund's benchmark. Source: Bloomberg, iShares, JP Morgan and SSgA. Past performance is not a guide to future performance and may not be repeated.

The roles for active managers

An increasingly important issue for individual savers and pensioners is the real world outcomes they want. It is questionable to what degree passive can help in this regard.

For example, as discussed earlier, many people simply want stable and reliable income in retirement. For these investors, success is likely to depend on allocating to the right asset classes.

This cannot be done passively. There is no index that can be aligned with a real world outcome, such as growing an investor’s money in line with inflation and still achieving income of 4% a year.

A newer dimension in the debate is the rise of “smart beta”. Instead of following a traditional index, based on market capitalisation, these passive funds select shares based on other criteria, such as yield or volatility.

A mix of these strategies has beaten index returns over the past 15 years and done so more cheaply than traditional active management. Even so, getting the best out of smart beta strategies will require decisions to be made over which ones to use and when.

These are decisions that cannot be taken “passively”. It is an active skill.

The unseen benefits of active management

It is also worth considering the role active investors play in the broader economy and society. Without active managers, asset prices would be based purely on the market size of companies, meaning there would be no mechanism to deploy capital in the best places and maximise returns for the benefit of the whole economy.

There is already evidence that recent large flows into passive funds are leading to distortions in markets.

We would contend that the stewardship activities of active investors raise returns in the capital markets by encouraging higher standards of corporate governance and directing capital into faster-growing industries.

This is a role governments in both Europe and Asia are encouraging. In Japan, in particular, policymakers are keen to see stewardship lead to better capital allocation, and everywhere managers are expected to exercise their voting rights responsibly.


There is a danger that, where active management has not met expectations, investors feel that they should abandon it altogether. But closer analysis of the data suggests many investors in active equity strategies have beaten passive funds after fees.

It is true that the characteristics of the US equity market make this the hardest market to beat. But we believe it is incorrect to extrapolate from the US to other equity markets, where there is no evidence that active performance is on a secular downtrend.

In bond markets capitalisation-weighted indices are both illogical ways to invest, and hard to track. And for investors who need to achieve a particular outcome, passive can be an impractical solution.

Moreover, active performance is cyclical. Active managers fare better in some environments than others, and selling out of a manager with a strong philosophy and process after a short period of underperformance risks locking in underperformance.

Investors need to use all the tools available to them: active, passive and smart beta. We would argue that the potential value added from active management remains critical to maximising the return from a broad portfolio, meaning that active management will in time start to regain share from passive.

This article has first been published on schroders.com.

Seven-year asset class forecast returns

Returns face further compression and investors seeking positive real returns would be advised to look at riskier assets: credit, equities and alternatives. Craig Botham, Emerging Markets Economist, provides a summary of Schroders' 2017 update on asset class returns forecasts.

Our seven-year returns forecast largely builds on the same methodology that has been applied in previous years, as explained in the appendix to this document; and has been updated in line with current market conditions and changes to the forecasts provided by the Global Economics team.

This document compares our current return forecasts to those last published in July 2016.

One key change this year has been a change to our methodology for forecasting credit returns, to incorporate the effects of quantitative easing (QE). A full description can be found in the appendix.


Table 1 below shows our forecast returns for the 2017–24 period. Cash and bond returns are largely expected to be negative in real terms, unsurprising perhaps given the continued low rate environment.

Investors seeking positive real returns would be advised to look at riskier assets: credit, equities and alternatives.

However, even here it seems positive returns are not assured. European credit and equities, for example, are both expected to yield negative real returns over the forecast horizon.

Table 1: Seven-year asset class forecasts (2017-2024), % per annum

Seven-year asset class forecast returns table

Note: *Thomson Datastream’s indices. Source: Schroders Economics Group, Schroders Property Group, July 2017.

This article has first been published on schroders.com.

Please find the full analysis of asset class returns here.

Is it time to focus on capital preservation, rather than capital growth?

It’s important for investors to draw a few distinctions between the short-run and the full market cycle – which is commonly measured as the market peak to peak, or trough to trough. Marcus Brookes, Head of Multi-Manager, and Robin McDonald, Fund Manager - Multi-Manager, both Schroders, look at the challenge and importance of emphasising capital preservation over capital growth as market risks build.

I made a fortune getting out too soon” ~ J.P. Morgan

In the short-run, market returns tend to be influenced most by a combination of investor sentiment, risk preferences and price momentum, all of which are interrelated.  Over the course of a full market cycle however, valuations are ultimately what matter. 

In the short-run, investors are often penalised for following the familiar approach of buying low and selling high.  Yet a full market cycle tends to be enormously forgiving to investors who decide to reduce their risk when markets are at or close to their high point. This is true even if investors do this a little bit too early, and miss out on the final stages of upside.

To emphasise this point, bear in mind that a five-year return profile of 10%, 10%, 5%, 5%, 0% beats returns of 20%, 20%, 10%, 10%, -25%.

The mathematics of compounding dictates that large losses have a disproportionate effect when it comes to amassing returns. Therefore, from a full-cycle perspective, avoiding them is critical. 

Investors always face the question of what to emphasise in their portfolios – capital growth or capital preservation. You can’t do both. In this note I want to deal with the challenge of emphasising the latter. 

This should not be mistaken as a forecast of an imminent market decline. It’s just we have always believed that successfully navigating the full market cycle is what matters most in the end, so we reflect upon the current conundrum quite a lot.

Most investors are wired with every bone in their body to do the wrong thing” ~ Howard Marks, Oaktree Capital

The purpose of our comparison between the two return profiles above is not to advocate permanently taking a defensive stance. Far from it. The point is more that the avoidance of losses is generally worth pre-positioning for. 

In the post-war period, the average US equity bull market has lasted approximately 64 months, and generated a gain of 163%. Within about 15 months from the peak, more than 50% of this gain has typically been lost to the subsequent bear market1.  So far, the current cycle has been both more profitable, and 50% longer than average, with gains in the order of 300% over 98 months2.

Now, we have no special insight into when the bull market in equities will end or indeed what will eventually trigger its demise.  Recognising this limitation, in the later stages of a cycle our approach has always been to gradually shift emphasis from capital growth to capital preservation over a period of time as market risks build - the objective being to carry less risk as the market hits its peak, than we do as the market hits its bottom.

This transition phase (which is gradually underway) is invariably frustrating and requires discipline and patience, as while momentum pushes prices higher in the short term it feels as though almost every single thing you do is wrong.  From a full-cycle perspective though, it’s perfectly rational, even if it does risk sacrificing some short-term relative performance. 

If everyone is thinking the same, then no-one is thinking” ~ Richard Russell, Founder of Dow Theory Letters

Judging by the avalanche of money currently pouring into passive investment strategies, we would submit that many investors today, consciously or not, are behaving with a higher degree of risk than normal.  We would contend that this makes some markets riskier than generally assumed. 

A false sense of security prevails over all financial markets at present due to low interest rates.  Many investors clearly believe the market environment is largely benign, safe and ostensibly primed for good future returns. We’re more guarded, particularly with the US.

It is true to say that today, the reward for taking risk has been extremely low for a prolonged period (or in other words, valuations have been high for some time).  It is the combined collapse in this (helped by low interest rates and quantitative easing) that has amplified returns during this bull market.  We suspect that neither of these will prove structural or permanent.

Similar to the late 1990s, today we have extreme capital concentration in the US markets.  Once again this has been partially driven by an innovation and technology boom.  Then, as now, the “value” part of the markets - a long-term investing approach which focuses on targeting companies which are valued at less than their true worth - are (relatively speaking) hugely unpopular.

So far in 2017, for the first time in a long time, US equities have started to underperform international markets.  From a value perspective, we believe this makes sense and may only be the beginning of a multi-year trend.  Outside of a brief episode in late 1929 and the period from February 1997 to August 2001, US equity valuations have never been higher than they are today.  From a full-cycle perspective they look unattractive and in time could prove far riskier than is presently assumed.

If everyone is going left, look right” ~ Sam Zell, Founder and Chairman of Equity International

US equities aren’t the only market we believe investors have overpriced.  Importantly, the US dollar has also enjoyed a bull market since 2011, which we believe may now be in the process of topping out.  And, of course, bonds have been in a bull market since 1981, leading to valuation levels today that are hard to comprehend.

If our observations on these three major asset classes prove to be reasonable, then it highlights some potential opportunities. It also underlines why some traditional solutions to our capital preservation conundrum may no longer be helpful:

  • Equities in relatively depressed markets – “value” investing  which is the art of buying stocks which trade at a significant discount to their true value, has been in the doldrums, relatively speaking, for about a decade now.  Below is a chart showing a ratio of US growth stocks against the MSCI World Value index, which recently surpassed its ‘tech bubble’ highs.  Although of course past performance is not a guide to future performance, you’ll note from the chart that from a similar extreme in 2000, value went on to radically outperform for many years.  What equity exposure we have remains tilted in favour of the value style, in part for this reason.
  • Alternative strategies - It's fair to say that from a full-cycle perspective we think there’s probably more risk to the growth style presently than there is absolute upside with the value style.  We think a good way to supplement this bias is therefore in strategies that have the ability to generate positive returns when markets are falling.  It is however important to note that such strategies involve additional risk as should markets rise instead of fall, large losses may be incurred.
  • Gold – during the phase of an economic expansion when earnings and profit margins are expanding, you’d expect assets with growing cashflows to outperform gold.  But in an environment where profit margins are already very high, bond yields are close to all time lows and the dollar is close to its peaking, we think gold becomes a more interesting proposition as part of a diversisfied proposition, with potentially good upside.
  • Cash – otherwise known as “dry powder”, has considerable value here, not because of the return it currently generates, but because of the opportunity it affords investors to establish more constructive positions as forward-looking returns improve. Being fully-invested in a bull market feels great. Being fully-invested in a bear market feels awful. For now, cash could be one way of lowering portfolio risk.

Many of the trends we’ve briefly discussed in this note have been going on for a long time: the outperformance of US equities; the relentless decline in bond yields; the bull market in the dollar; the relative bear market of active management, particularly with a value bias.  As such, investors get used to them and become almost resigned to their persistence.

We believe this is exactly the time when being active, patient and disciplined could add most value from a full-cycle perspective. We remain alert to profiting from the opportunities that may present themselves as these trends begin to tire.



Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Alternative investments, including commodities, involve a higher degree of risk and can be more volatile and less liquid than shares and bonds. They should only be considered as a long term investment.

This article was first published on schroders.com.

1) Majedie Asset Management 2016
2) Lipper, as at 31 March 2017