Do global markets favour active stock picking?

by Olivia Barbee, Wells Fargo Asset Management

Non-U.S. markets have attributes that may favor active stock selection versus a passive approach. To start, let’s look at the data to gain a sense of how the active approach has fared in global markets. According to Zephyr, in recent years mutual funds in Morningstar’s foreign large-blend category have often performed better on a trailing three-year basis versus their group index—the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Index—which includes developed and emerging markets equities.

Specifically, active managers outperformed in the period directly following the global financial crisis. As shown in the graphic below, performance for foreign large-blend funds began to outpace that of the index in the first half of 2013, a trailing three-year period that began in 2010. The funds maintained their trailing three-year advantage until June 2016, when the index recently regained favor.

How have foreign large-blend mutual funds fared versus their group index?

The full period of the funds’ advantage included major events such as the Greek government debt crisis, the banking crisis in Cyprus, the beginning of the conflict in Ukraine, the collapse in the price of oil and other commodities, a major corruption scandal in Brazil that resulted in impeachment proceedings against its president, and the shock vote of the United Kingdom to exit the European Union.

The heightened volatility of past years might explain why the relative performance for active managers improved relative to the benchmark, for two inter-related reasons.

First, in an increasingly volatile global environment, active managers have the ability to study macro events—think central bank moves, countries’ political conditions, and in-progress economic growth trends—and adapt their approach to changing conditions. Second, the large investment universe available to international managers gives them the scope to translate their views into positions that differ from the benchmark, pursuing what’s known as high active share.

1. Active managers can respond to changing expectations

As mentioned above, the international space has been an unusually volatile one in the past few years. Besides the major shocks mentioned earlier, less-acute concerns have included the magnitude and effect of the slowdown in China’s economy and whether Japan’s Prime Minster Shinzō Abe would be able to push through reforms capable of reinvigorating his country’s economy.

Managers typically take one of two approaches in such volatile times.

Some have found that a tactical approach, implemented within a well-defined investment process, has added value. For example, Portfolio Manager Dale Winner previously focused on German and Italian industrial companies, looking for those that could benefit from self-help changes such as restructurings or from political reforms. Lately, Winner says that “We are looking at U.K. exporters, which could benefit from the weaker pound.”

Other managers focus on broad thematic plays that they tailor to changing conditions. Portfolio Managers Jerry Zhang and Derrick Irwin have maintained their focus on companies that stand to benefit from the growing middle class, especially in China. Within that broad theme, Zhang and Irwin focus on companies that are evolving their product suites and distribution networks to adapt to evolving consumer tastes.

2. Active managers can use a large investment universe to achieve high active share

The concept of active share was introduced in 2009 by professors K. J. Martijn Cremers and Antti Petajisto of the Yale School of Management. Active share represents the portion of a fund’s portfolio holdings that differ from the benchmark’s holdings.

In a paper titled, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” the Yale professors stated: “Active share predicts fund performance: Funds with the highest active share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest active share underperform their benchmarks.”

According to their research, funds may achieve higher active share in one of three ways:

1. By owning stocks that are not in the benchmark
2. By excluding stocks that are in the benchmark
3. By holding benchmark stocks in weights that differ from those of the benchmark

Although active managers could theoretically achieve high active share against any appropriate benchmark, a broader investment set would get them more opportunities to select, deselect, or overweight particular stocks. As John Rekenthaler of Morningstar once explained, “If the benchmark contains few companies, with the largest firms accounting for much of the assets, then the fund will likely have a lower active share score … in contrast, it’s easy to receive a high active share score when the benchmark is diffuse.”

Below are the number of securities and the percentage of concentration of top 20 holdings for a select group of domestic and international indexes as of August 31, 2016. The data suggests that breadth and diversification have tended to favor the international side.

Several international indexes have offered the greater breadth that made it easier to achieve higher active share

Source: FactSet

Index definitions

Conclusion

The ability to use the broad opportunity set across international markets to adapt to changing conditions could be an advantage in unusually volatile times. We believe that active managers who take advantage of those opportunities have the best chance to outperform.

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