Skilled Stock Pickers Separate Themselves In Periods Of Heightened Volatility

Is the outlook for active management still favorable?

In a previous article, we highlighted the gauges we look at to monitor the active management environment and discussed how this could play out in a risk-managed multi-manager fund. We expressed optimism in the opportunity set, and the ability for active management to generate excess returns coming out of the pandemic. While ensuing market dynamics proved to be beneficial for active managers, the world remains stuck in a prolonged COVID-19 recovery period, with persistent market uncertainty and ever-evolving market dynamics that continue to challenge our thinking.

In this article, we will highlight why we remain optimistic of the active management environment and the ability to generate excess returns through a multi-manager approach. Ultimately, we believe the current uncertainty, falling cross-sectional correlations and the possibility of market volatility present a unique opportunity for active managers, regardless of underlying style preference.

Uncertainty is for certain

The number of concerns among investors are endless, though the top of the list includes inflation, stagflation, corporate earnings and the green energy transition, all of which carry a large degree of complexity and uncertainty. JPMorgan (JPM) strategists expect a rebound in stocks, driven by favorable risk/reward dynamics¹, while strategists at Morgan Stanley (MS) expect corporate profit margins to contract into 2023 due to sticky cost pressures and receding demand.² UBS (UBS) has acknowledged economic data remains uncertain, warning investors that markets may remain volatile in coming months.³ What do we take away from these mixed signals? Uncertainty is for certain—but with uncertainty comes opportunity.

Falling cross-sectional correlations lead to broader opportunity set for stock pickers

As covered in our previous article, we monitor cross-sectional correlations as one of our gauges for the active management environment. Since early 2021, cross-sectional correlations have continued to fall, increasing the breadth of idiosyncratic opportunities for active managers. Current market dynamics have led money managers to emphasize the importance of finding companies with competitive advantages and defined moats, along with the ability to pass pricing on to end consumers. We believe the ability to identify these characteristics, during a time with increased breadth, creates an increasingly favorable opportunity for active managers to generate excess returns—particularly if we experience heightened volatility moving forward.

Skilled stock pickers separate themselves in periods with elevated volatility

The combination of high uncertainty and falling cross-sectional correlations presents a compelling landscape for stock pickers, particularly skilled stock pickers in periods with elevated volatility. The charts below illustrate the difference in excess returns among global large cap managers performing in the 75th percentile vs. the 25th percentile, in relation to cross-sectional volatility dating back to 2000.⁴ In periods with heightened volatility, skilled stock pickers tend to add additional value relative to peers compared to periods with standard market volatility. And this isn’t just true for a small subset of the market—both value and growth universes exhibit similar trends.

This is an extremely important phenomenon for several reasons:

1. Avoiding value AND growth traps (yes, growth traps are a thing too!) is important
   In periods of higher volatility and uncertainty, stocks without the right fundamentals to succeed will be exposed for all to see. This underscores the importance of having a value manager that understands why a company is trading cheap and why it might rebound, as well as having a growth manager that truly grasps expected drivers of future expansion to justify a stock’s current valuation.

   Skilled stock pickers clearly have the edge here—the charts below show that money managers who possess skill across the growth and value spectrum add meaningfully to excess returns in times of greater volatility.

2. Identifying skill in a money manager is hard
   Just like picking good stocks is hard, so is picking good stock pickers. Many factors go into a successful money manager research process. If you don’t have robust manager research in-house, partnering with a firm that does is paramount to success.
3. Timing managers and styles is even harder
   We believe that a multi-style, multi-manager approach is your best path to success in navigating the troubled waters that are certainly still ahead of us.

A skilled multi-style, multi-manager portfolio: Less filling AND tastes great!

A multi-manager approach is often viewed as a means of diversification and risk mitigation (i.e., less filling). What’s often underplayed is the excess return potential (i.e., tastes great), driven by the ability to tap into differentiated expertise in subsets of the market. This is especially relevant (and exciting) in an environment like the present, where we believe active management will benefit from broad tailwinds, regardless of style preference. The ability of skilled stock pickers to generate excess returns in their specific subset of the market provides benefits that can be additive when combined with other style experts. We’ll expand on these benefits in a forthcoming article.

The bottom line

With uncertainty comes opportunity. And while the active management environment has improved since COVID-19, we believe the market continues to present favorable dynamics for active management moving forward. An increasing opportunity set, and the possibility of increasing volatility presents tailwinds for stock pickers and provides a broader opportunity for skilled stock pickers to differentiate themselves from peers. Ultimately, we believe that investors can enhance their excess return potential through a multi-manager approach, and we remain optimistic in the ability of skilled managers to generate excess returns through bottom-up stock selection, especially during times of uncertainty.

¹ Source: eVestment universe, Russell Investments, SS&C, MSCI

² Source: JPMorgan’s Kolanovic Says Time to Trim Stocks, Buy Commodities – Bloomberg (August 9, 2022)

³ Source: Wall Street Strategists Say Stocks Rally at Odds With Profit Outlook – Bloomberg (August 8, 2022)

⁴ Source: Stock markets will remain volatile for the next few months despite their July rebound, according to UBS

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

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