The current market volatility is a prime opportunity for active investment management, provided the manager is truly skilled and disciplined, said three industry experts on a panel at the Inside Alternatives & Asset Allocation virtual conference.
“To declare this cycle as unique is an ultimate understatement,” Liz Ann Sonders, managing director and chief investment strategist at Charles Schwab, said during the discussion, which was conducted Sept. 29 and broadcast this week at the conference presented by Financial Advisor magazine and MoneyShow. “I think the easiest way to frame it without rehashing three and a half years is to go back to the stimulus era of the early part of the pandemic.”
Sonders was joined by Sebastien Page, head of global multi-asset and chief investment officer at T. Rowe Price, and Omar Aguilar, CEO and CIO at Schwab Asset Management, as they discussed market trends and examined the roles of active and passive management today.
While the pandemic stimulus boosted the economy, Sonders said, the boost was on the goods side of the economy because no one had access to services. This became the breeding ground of the later inflation problem, and then the rolling recessions in housing and manufacturing.
“We’ve had recessions in those segments, it’s just been offset by later strength in services,” she said, adding that the services sector is a larger employer. “I still think a recession in terms of a formally declared one is more likely than not, but it’s a more nuanced way to think about things.”
While the panel agreed that the economy will not be returning to what it was before the pandemic, each speaker had a different view on what that means. For Sonders, the pre-pandemic normal will be replaced with a more “temperamental” era akin to the 30 years or so that started in the mid-1960s, with more economic and inflation volatility.
“It’s a different way we have to think about the macro landscape and investing,” she said.
Page said he looks at four economic regimes since World War II—the post-war boom, the stagflation of the 1970s, the old normal marked by the multi-decade bull market in interest rates, and the new normal beginning with the Great Financial Crisis and zero rates.
“If you look at where we are now, with Fed funds above 5%, and with inflation at 3.7% year over year, it’s a fair question to ask: Are we in a new regime?” Page said. “We’re definitely in a new regime by definition, but what does the new environment look like statistically?”
We have exited the new normal of low inflation and low interest rates, he said, adding that his models show that we’re not in a stagflation.
“It’s kind of a coin-toss between old normal and the post-war boom, interestingly, especially given the low unemployment,” he said. “So my conclusion is that there is life for markets above 5% Fed fund rates. High rates don’t have to necessarily take the oxygen out of the markets as much as the narrative suggests.”
Page said he’s not overly bullish, but now is neutral between stocks and bonds.
Aguilar said thtat at the very least we’ve passed the end of “free money.” The upside of that is the ability to now get income out of bonds.
“It sounds like a revelation, but it’s actually just something we haven’t had for a while,” he said.
In terms of portfolio construction, Schwab is less sector-focused and more factor focused, Sonders said, meaning that they suggest investors screen for characteristics and factors as opposed to just sectors. Factors include things like strong free cash flow, interest coverage and profit margins.
“That’s where our focus has been,” she said. “We will continue to make recommendations at times at the sector level, but we’ve been factor-focused.”
Page said he starts with assets classes and looks at underlying sectors, but ultimately relies on characteristics for the building blocks of investments. Those include value, size, interest rates, spread risk, and in the multi-asset perspective there’s always the question of what the portfolio looks like when put together.
“Recently we did a sector analysis of asset classes, and the conclusion was to support our position at the asset class level,” he said. “We do like to lean into real asset equities.”
That real asset equities bucket is made up of REITs with active management under the hood trying to avoid the pitfalls of commercial real estate, he said. There’s also metals and mining, precision metals, utilities, and natural resources.
Aguilar said that his take on asset allocation returns to the fundamental idea of capital market efficiency, where in the world of investments if everyone had the same information at the same time, then everyone would have the same allocation.
“But that doesn’t exist,” he said. “So you’re not picking individual stocks or individual bonds at this level, but you’re picking asset classes. Did you buy equities or fixed income? Did you buy large-cap versus small-cap? Did you buy international or domestic? Technology over energy? High quality over high growth?”
From there, Aguilar said he looks at security selection. But the decision about portfolio construction starts with choosing a mix that aligns with one’s risk profile.
Sonders reminded the audience that in 2022 active managers had their best year relative to benchmarks since 2005.
“I think the playing field is getting a bit more level for active to have some chance of performing well,” she said. “Should an investor have a combination of both [active and passive]? One over the other? How does this fit in portfolio construction?”
Page said that when he thinks and talks about active management, he cares deeply about what skill active management can deliver consistently.
“There aren’t that many skilled active managers, but some of them deliver added value over decades,” he said. “And people retire with an extra $100,000 or $200,000. It really matters what skilled active managers deliver to investors over time.”
Skilled active management relies on deep research, significant investment in proprietary research, relatively low fees, discipline, and a replicable process.
“At the end of the day, you can’t have passive investing—it cannot exist—without active managers,” Page said. “Active management plays a role in price discovery.”
Aguilar said that the current environment is much more friendly to active management, or a combination of active and passive, than was seen in the last decade. This is because the one thing that active managers need to do well is volatility.
“The one thing that all active managers have in common is that they try to exploit that volatility premium,” he said. “In other words, you need to have differentiation. Last year, the spread between technology and energy was so huge if you had the right manager with the right skill that was able to overweight energy and underweight technology—beautiful.”
