How much does active management contribute as compared to passive management? With this question, Michael Roberge, CEO, President and CIO of MFS Investment Management opened his presentation at the 2017 MFS Annual Global Analyst and Portfolio Manager Forum, which took place in Boston in mid-May.

According to Roberge, some of their larger and more sophisticated clients, including those who manage sovereign wealth funds and pension plans, are increasing their positions in actively managed funds, contrary to what the average retail client is doing. During his talk, he explained the main reasons why clients should, according to MFS, consider active management in this environment, compared to investing passively.

The Short-Term Mentality of the Bulk of the Market

In the period immediately following Donald Trump’s election in November last year, the market rose between 6% and 7%. For Roberge, even more noteworthy than this rally, was the massive turnaround from the more defensive and higher-quality sectors to much more cyclical sectors, with the expectation that the new administration would reduce taxes and that the regulatory burden would be lower. Likewise, any increase in economic growth was traded: the price of deep cyclical stocks soared and consumer staples companies suffered a fall in prices. This was caused in part by investors who pursued these sectors out of fear of falling behind the benchmark in terms of performance. In a clear example of how the short-term mentality dominates the behavior of the markets, more than five months after Trump’s takeover, a new rotation in the opposite direction was happening. Investors have begun to perceive that it will be difficult for Trump to get approval for significant spending on infrastructure, and that he lacks support for much of his election promises.

According to Michael Roberge, this was clearly reflected in the deep cyclical sectors: US Steel’s stock price, which was US$ 21 per share pre-election, doubled to US$ 42 per share, only to returning a few months later to US$ 21. Meanwhile, MFS ‘strategy was to sell cyclical stocks and buy defensive stocks. The asset manager’s teams look for returns with horizons of three-to-five years, identifying long-term opportunities. This is where the firm thinks it has the greatest opportunity to add alpha to a portfolio.

Higher Volatility

Another factor playing in favor of active management is the minimum volatility period experienced in the last decades. This is largely a consequence of the accommodative policies of central banks.

The European Central Bank, as well as the Bank of England and the Bank of Japan continue with quantitative easing programs; and while the Fed appears to be at the beginning of a rate-hiking cycle, Roberge argued that when inflation is considered, the real interest rate of Federal Funds is negative, which is especially stimulating for an economy growing at around 2%, with the potential to grow at 4%. In the CEO’s opinion, it could be said that all central banks globally, continue to inject liquidity into the system, which not only keeps interest rates low, but also suppresses market volatility.

MFS claims that, in the next ten years, a low growth scenario will persist globally. There is a problem of over-indebtedness and an aging global population in the major developed economies which will cause the world economy to remain below its potential.

For Roberge, the only way to achieve greater growth in real terms would be by fostering an increase in the labor force, something which new immigration policy trends are slowing, or increasing productivity. This last variable is the one that can best be implemented by governments worldwide.

“The global economic environment is still more deflationary than inflationary. In Japan, they have been trying to generate inflation for over 30 years, something that is also beginning to happen in the United States. The latest inflation data (with respect to the previous year) have been downward, even only taking into account the underlying inflation. It could be said that there is an inflation problem at the global level,” said Roberge.

Given these factors, MFS believes that investors can expect a world with lower economic growth, in which there will be greater volatility, as economies will face greater challenges. “There will be new episodes of uncertainty in Europe: Greece will reappear in news headlines due to debt renegotiation, and Italy will hold general elections in May 2018. And finally, the moment central banks begin to remove excess liquidity from markets, higher levels of volatility will be created, which, when added all up, represents a huge opportunity for active management as compared to passive,” he added.

For Roberge, this does not mean that a portion of the portfolio shouldn’t be invested in passive management vehicles, but how much is being spent on active management should be reconsidered.

A Disruptive Environment

According to MFS, another one of the fundamental keys that indicate that it will not be enough to buy the index to achieve the investment objectives is disruption. A large number of industries are going through a disruptive period: “The most obvious example is the retail sector where Amazon is crashing its competitors in the traditional retail segment. More and more sectors are undergoing a period of transformation: Airbnb, for example, has led to a similar change in the leisure industry, Uber has broken into the taxi industry, robo-advisors and smart beta ETFs have hit the financial industry. All of these examples, which highlight the complexity of the environment, make passive management less attractive.”

Now More than Ever, Investors need Active Management

Continuing with the discussion, Roberge highlights two reasons why investors should consider positioning themselves in actively managed vehicles: return and risk management. In relation to the return of the markets in the next ten years, the asset management company expects a global equity return of around 4.3%. This figure is considerably lower than historical returns, especially since starting valuations are very high, meaning most of the opportunities are already priced into the current market prices.

Meanwhile, the expected return for the same term in global investment grade fixed income is roughly 3%. Historically, rates are at very low levels, leaving very little room for capital appreciation gains, and leaving only the coupon search and the spreads on corporate debt as the main source of return for this asset class. Therefore, according to MFS, the average investor who invests in a balanced portfolio could achieve an estimated annual return of close to 4% over the next decade.

These returns make it extremely difficult for the bulk of investors to achieve their retirement goals. Therefore, they will need an additional source of return to achieve their goals, something that can only be achieved through active management and alpha generation,” Roberge said.

In this regard, the alpha in portfolios becomes a more important element than ever. According to MFS projections, for US large cap equities, the contribution of active management in terms of excess return on the index will increase from the 17% registered historically (2% over 10.1%), to 42% (2% over 2.8%). While in fixed income, active management’s contribution will increase from 12% (1% over 7.5%) to 24% (1% over 3.1%).

However, investors have recently stopped believing that there is alpha opportunity and lean instead passive management, seeking only lower commissions, regardless of net returns. In ten years, these investors will be very disappointed if indeed the MFS forecasts are met and their index returns are limited to below the 4% offered by the market, regardless of how low the fees charged by passive vehicles may be. For all of the above, Roberge encourages reconsidering active management as the main way to reach long term investment objectives.

The extent of the current geopolitical situation worries investors who focus their discussion between continuing to bet on risky assets or moving toward “haven” assets. Where should investors put their money? During his presentation at the 2017 MFS Annual Global Analyst and Portfolio Manager Forum,James Swanson, Chief Investment Strategist at MFS Investment Management, reviewed what’s happened during the last cycle to determine where the global markets are now, and how investors should position themselves.

The Starting Point

After the market collapse in 2008, when US equity indices fell nearly 50%, the financial press maintained that investment in US stocks was not going to pay off, as GDP growth over the past eight years was well below the 3.5% at which it used to grow. However, Swanson argued that the measure that should really have been taken into account is the generation of free cash flow by companies. In the United States, this metric grew dramatically, reaching levels not previously observed.

Several factors enabled this development, one of the main being globalization. With the onset of the crisis, the American working class was forced to sell its work at a low price, so the companies had an extremely cheap labor force. Likewise, the reduction of interest rates carried out by the Federal Reserve allowed a considerable reduction of the cost of capital. In addition, the use of new technologies allowed the transformation of assets at a lower cost. These elements had repercussions in better ratios, better margins, and finally greater free cash flows.

And where is the cycle now?

Comparing levels of confidence indicators, the so-called “soft data” encompassing various investor sentiment surveys, with data on housing, industry, labor and consumption, known as “hard data”, one can observe a great divergence between both. The fundamentals of the economy lie far below the euphoric feeling that investors are showing, something Swanson says had not been seen before in several cycles. The next question to ask is how these two tendencies will converge.

To clarify this point, Swanson showed the evolution of performance in terms of real cash flow in the US equity market, or what is the same, if one invests a dollar in the S&P 500 index, how much cash flow is obtained after discounting inflation. In the long term, the real cash flow is around 2.6%. During the last recession, this measure fell sharply, but in the next two years it experienced a spectacular recovery, and now, while we are in the last stage of the cycle it has reverted to its long-term average. This, suggests that fundamentals are starting to whip in at the same time market valuations are extremely high.

Even though there is a notion of reflation in the environment, Swanson pointed out that core inflation in Europe, the United Kingdom or the United States is far from the 2% level that central banks would like to see. Another disconnect between perception and reality, in the MFS strategist’s opinion, the massive underlying reflation which sentiment is indicating is not happening.

Clouds on the Investor’s Horizon

One of the first concerns that investors should bear in mind is the growth of consumer income in real terms. Swanson has observed that wage in the last cycle has been somewhat subdued in the United States, Europe and the United Kingdom. He pointed out that it would probably be a residual component of the last recession and the demography of these countries. “Globally, we are going through a particular moment in time, in which baby boomers are retiring from the workforce and are being replaced by a generation with lower wage levels. Incomes in real terms are lower and this is going to have a direct effect on spending.”

The second cloud on the horizon is the economic situation in China. Just a year ago, China’s credit system was expanding, with lower interest rates and greater liquidity. But now the situation is different, government spending has fallen, consumption taxes have risen, housing purchase credit has been tightened and the Shibor rate, the Shanghai interbank rate, is starting to rise. “Every time they have made this kind of movement within the investment cycle, putting the brake on their economy, the consequences have been suffered globally. China is the largest marginal commodity consumer, and commodities play a key role in global inflation levels. At present, we can appreciate a weakening of the price of commodities. However, China has not entered into recession, nor is in the process of doing so, but will see a slowdown in consumption and spending because the monetary impulse is decreasing. This will have repercussions on exports from the United States and particularly from Germany,” Swanson said.

The third cloud that investors should not lose sight of is the production, consumption and the point of the economic cycle in which the United States is currently in. Industrial production, as measured by the ISM Manufacturing PMI index, tends to follow the movement of the money supply. In general terms, a pattern can be observed in which, whenever there is greater liquidity in the system, manufacturing production accelerates and expands. Currently, the real money supply is slowing its growth, showing an anticipated signal that production will also fall. So the bet on reflation may not be sustainable over time. Sales of new residential homes and automobiles are slowing, as are sales of consumer products. Therefore, Swanson invites all those investors who are thinking of increasing their position in risk assets to match the current valuations with the risk of going through a small pullback during the summer or with the risk of entering during the latest phase of the cycle: “We are reaching the eighth-year of the cycle, while the longest cycle ever recorded was 10 years. If you compare the economic situation of the United States with that of a patient who goes to the doctor, we would be talking about a 78 year old person, who could have died a couple of years ago, but is still enjoying relatively good health,” he argued.

Some of the signals that indicate an advanced moment in the cycle are already showing: euphoria replacing fundamentals, a squeeze in margins, and a slowdown in consumer spending. However, what is even more worrying for Swanson is that companies are not reinvesting in their own businesses. According to the MFS strategist, the historical evidence is very clear: companies that can reinvest their capital and obtain a return which is higher than that on their capital, over the long term, their stocks have often outpaced the market. However, companies in the United States, which find themselves with massive amounts of cash flow, decide to repurchase their own stocks or increase their dividends.

The Promises of the Trump Administration

Finally, new accusations of obstruction of justice faced by the US president could have serious consequences, increasing uncertainty and instability in the markets. In any case, if the difficulties faced by the new administration can be solved, infrastructure spending would not be sufficient to compensate for the lack of private sector momentum, and the effects would be lengthened over time. Likewise, the contributions of the promised fiscal reform are not expected to be as relevant as those achieved in the Reagan era. This is, because the baby boomer generation is leaving the workforce and there will no longer be the positive impact of the incorporation of women into the working world in the 1980s. In addition, the proposed tax cuts will affect only roughly 20% of the US population, typically wealthiest individuals, who have a much lower propensity to consume than the working class, and which therefore, will not be a significant stimulus. In summary, according to MFS it is difficult for the US expansionary cycle to go on for much longer and current market valuations are very high.