Hi, I’m Kevin Barr, Head of SEI’s Investment Management Unit. Stock markets are showing a level of volatility that is extremely concerning to many investors. With that in mind, I’ve asked Jason Collins, our Head of Equity Portfolio Management, to join me today.
Thank you for joining me Jason. I’d like to start by asking you how the current market conditions are impacting our portfolios?
With markets down close to 30% since the outbreak of the current crisis, portfolios have clearly been hit hard in absolute terms.
Initially it was energy and commodity stocks, and airlines and other companies whose earnings were expected to suffer most from a reduction in global travel that fell most sharply. Whilst we are not typically over represented in these sectors, previously attractive valuations have meant that we have had exposure, and in some of our funds this has detracted a little from relative performance.
As the crisis has unfolded and whole countries have gone into lock down, sharp falls have spread to the banks and other sectors as recession and widespread bankruptcies become inevitable. On some of the worst days selling has been almost indiscriminate, with stocks falling across the board, leaving no hiding place for active managers who must remain fully invested.
This has been a challenging environment - panicked selling creates a lot of volatility in the short term, with share price movements not really reflecting the underlying fundamentals. This of course creates opportunities in the longer run for those investors able to stay calm, measured and focused on their long term objectives.
That said, we have not yet seen elevated turnover and wholesale changes to portfolios as, whilst markets have sold off significantly, market leadership and the prevailing trends have not changed course materially. Sectors such as Energy, Financials and Airlines had been out of favour for some time (and were thus already viewed as good value by our value managers). Conversely higher quality, higher growth companies in the Consumer Staples and Technology sectors that have proven more resilient were already in vogue and well represented in the portfolios of our Momentum and quality (or Stability) oriented managers.
At some point we can expect these trends to reverse.
KEVIN : Where are we seeing opportunities arising from this crisis?
Prior to the recent sell off, equity markets were looking somewhat richly priced, particularly in the US. Much of the market rises we saw over 2019 were a result of improved sentiment (and hence multiple rerating) rather than underlying earning growth.
With markets now close to 30% lower, valuations are looking more attractive – particularly in light of this month’s emergency interest rate cuts and the fact that this crisis is likely to be just a temporary (albeit very painful) hit to earnings rather than anything more permanent. This has provided both investors and active managers with opportunities to start putting any surplus cash to work, although it would be prudent to do so incrementally given volatility is likely to remain very high. I know that this can be very difficult, but the best opportunities often arise when it feels most uncomfortable.
In relative terms, our equity portfolios are strategically positioned to benefit from 3 systematic long term sources of excess return, namely Value, Momentum and Stability. Additionally we look to the stock specific insights of our sub-advisors, to add value. Over the full cycle stocks that are attractively valued, higher quality or lower risk, and enjoying positive change are expected to outperform.
Whilst our funds are well diversified across each of the 3 alpha sources, in recent times, extremely wide valuation dispersions have lead us to favour value, although the magnitude and nature of this tilt has varied across the funds, depending on opportunities that both we and our sub-advisors see in the different markets.
The current crisis has exacerbated this opportunity, with already out of favour stocks faring worse than more highly rated defensive / quality growth stocks, thus offering even better relative value.
To give some more colour, the gap between the cheapest and most expensive stocks in the market is as wide as it has been since the Tech bubble 20 years ago. As this gap normalises and closes, we can expect cheaper stocks to outperform more expensive stocks significantly.
We are therefore sticking with our preference for Value, and will use any fund flows to maintain and, where appropriate, reinforce this position – although any shifts in the short term are likely to be very gradual given the ongoing volatility. Similarly, we are seeing some of our underlying sub-advisors make modest shifts, adding to or picking up oversold stocks (even airlines in some instances!) where underlying long term fundamentals remain robust.
KEVIN : How are the portfolios positioned for the eventual rebound?
The first thing to say is that markets are likely to remain very volatile as the continuing pandemic unfolds and the economic impact becomes clearer.
Markets could fall further from here. However, once the situation stabilises, then we can expect a sharp recovery, just as we have seen after other crises in the past.
The precise timing of any such recovery is difficult to predict but recent actions taken by both governments and central banks around the world will hopefully be enough to fend off the worst economic outcomes and should provide a sold floor under markets once rates of infection slow, and thus provide the foundation for a rebound.
In the short term, market recovery phases are often driven by the most oversold “value stocks” in the market, as improved sentiment and expectations leads to investors to rotate out of more expensive, more defensive names in search of a bargain.
As mentioned previously, whilst our funds are well diversified across each of the 3 alpha sources, in recent times, we have tended to favour value across the funds. Our portfolios should therefore be well positioned for any short term market recovery.
Longer term, the emergency stimulus measures that we have seen are likely to prove inflationary, an environment that tends to be more supportive of value investing, as the valuation of longer duration growth stocks falls as a result of higher bond yields. If this trend does become established then we would expect our momentum bias to also benefit alongside our value tilt.
We will of course continue to monitor market developments closely from here to ensure portfolios remain well positioned for the current environment without losing sight of our long term strategy.
KEVIN : Do you think this time is a good time for active management?
Active managers have had it tough in recent years as market returns have been narrowly concentrated in a small number of very large, high growth (and often very over valued) technology related stocks (the so called FAANGs). In contrast, most active managers have tended to build more diversified portfolios, with holdings outside of the mega cap market leaders. Usually this pays off, but not over the last few years.
This trend has been driven in part by a prolonged period of favourable tailwinds from very low interest rates and ample liquidity. Now that market conditions have turned more challenging, the hope is that active managers will be able to perform more strongly than the market cap weighted benchmarks.
It is certainly true that outperformance of the largest companies in the market cannot last forever – you only have to look back to see how much the list of the biggest companies in the world has changed each decade. This rotation from “yesterday’s winners” to “tomorrow’s winners” does create a more favourable environment for active managers as stock returns diverge and market indices become less concentrated.
This current crisis and the fiscal stimulus that it has prompted may well prove to be the catalyst for a regime shift, in which we see the FAANGs no longer dominate market returns, and active managers go on to outperform market cap weighted benchmarks.
So far, it’s too early to tell. Periods of extreme market volatility are always challenging for active managers as share price moves tend to be highly correlated and often fail to reflect the underlying fundamentals of individual companies.
But we advise patience. As the pandemic stablises and the economic impact becomes clearer we should see market participants become more discerning – potentially rewarding those companies whose fundamental strength and growth outlook is not reflected in valuations, or those that are beating expectations. When this happens, active managers following a proven approach should at last reap the rewards.
Thank you Jason.
Glossary of Terms:
- Alpha source: Our strategies are designed to capitalize on long-term drivers of market performance through exposure to persistent sources of returns such as mean reversion, trend-following and stability. We have refined our approach to identifying these alpha sources and the factor groups we employ as proxies to measure and capture their performance.
- Momentum Alpha Source: The investment manager seeks to benefit from investor under-reaction—due to anchoring. Such groups of stocks trend in price as perceptions change directionally and serially with incoming data, leading to herding behavior by investors.
- Stability Alpha Source: The investment manager seeks to benefit from investor tendency to undervalue lower-risk, higher-stability businesses—resulting from a focus on short time horizons and overconfidence in forecasts for momentum-driven stocks. Stability-oriented stocks have the power to exceed market expectations by consistently outperforming (rather than reverting to average market returns) and through the power of stable, long-term compounding.
- Value Alpha Source: The investment manager seeks to benefit from investor overreaction—resulting from aversion to loss. Such groups of stocks revert to the mean, as fear over the perception of the investment’s risk dissipates.
- Basis point: One basis point is equal to 1/100th of 1%.
- Beta: Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
- Correction: A correction is a decline of 10% or greater in the price of a security, asset, or a financial market.
- Correlation: Correlation is a statistic that measures the degree to which two securities move in relation to each other.
- FAANG Stocks: FAANG stocks are Facebook, Amazon, Apple, Netflix and Alphabet (formerly Google).
- Price-to-Earnings Ratio: The price-to-earnings ratio is the most recent price of a security divided by the company’s annual fiscal year basis earnings per share. Price to book ratio is the most recent price of a security divided by the company’s annual fiscal year basis book value per share.
- Standard Deviation: Standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is for educational purposes only.
Investing involves risk including possible loss of principal. Narrowly focused investments and smaller companies typically exhibit higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There can be no assurance that strategies discussed will or won’t be successful.