Paper: Opportunities Scarce for Active Managers, Risk Recovery on the Horizon

(April 30, 2012) — Opportunities for active equity managers to make outstanding returns for their clients were scarce in 2011, according to a recent whitepaper by Wellington Management.

Macro-driven risks associated with political and fiscal uncertainty, which caused unprecedented high correlations, were the greatest culprits, Wellington said. The firm also said that because of the scarce opportunities for active managers, they should focus on securities in which they have a truly different opinion. “Trying to time 10% movements in stocks, industries, or countries won’t move the needle much overall,” Wellington said.

Consequently, according to the firm, the focus on safety among investors was nearly as extreme in 2011 as it was in 2008, when the market was down almost 40%. “We found that while 2011 and 2008 ended with very different market returns, they shared many traits, including massive risk aversion and an extremely narrow opportunity set of market-beating stocks, which severely limited the ability of active managers to add value,” Wellington asserted. “The good news is that historically these flight-to-safety periods have tended to be fairly short-lived, and if that trend holds, we would appear to be on the cusp of an excellent period for risk assets.”

While few of the typical warning signs of a return to safety within portfolios were triggered in 2011, many of the early indicators of a risk recovery are emerging, Wellington concluded, outlining the following factors:

1) High-yield spreads are contracting.

2) Volatility is moderating, and the volatility curve is no longer inverted (short-term volatility is now lower than long-term volatility).

3) Housing and housing stocks are turning in some surprisingly good results.

4) China has been one of the better-performing non-US markets recently, and several of the country’s leading indicators have turned positive.

Wellington’s conclusions regarding active equity managers contrasts with another report by the firm released earlier this year, which asserted that equities will have long-term return benefits for most investors despite the asset class underperforming bonds over the past 15 years.

Ultimately, the authors of the report on equities over the long-term concluded that they believed investors should base strategic asset allocation decisions on fundamentals and valuations, rather than on recent returns. While allocations to other areas of fixed-income or to alternative asset classes may be appropriate, there are often limits to their use, such as liquidity constraints and the skill required to select and monitor complex strategies. Thus, the paper asserted: “We believe that current market conditions and historical capital market behavior suggest that now is a good time for investors to examine their fixed income and equity allocations to determine if they have the appropriate exposure to equities to meet their long-term objectives.”