Active vs. Passive Equities: Picking the Best of British during COVID-19 volatility
The debate about active versus passive investing has rumbled on since John C Bogle created the first index fund in 1975.
In recent times, markets have been underpinned by central bank intervention, and a large chunk of investment capital has been allocated to passive vehicles. These strategies attempt to mirror the performance of a particular market or index such as the FTSE 100. When prices are following a steady upward trend - as they mostly have over the past decade - it is possible to build a case for passive strategies. However, this becomes far more difficult when markets become volatile, as they have this year.
Naturally, this leaves many investors asking themselves an important question. Does it make sense to invest in passive strategies which give no consideration to a company’s individual fundamentals or their relative value? After all, these strategies have no one at the helm to navigate tricky conditions. If the market falls, passive vehicles will follow.
The benefits of staying active
In more volatile market conditions, extreme share price movement gives active investors the opportunity to potentially benefit. Essentially, if prices are very volatile, the market is inefficient - and inefficiency leads to opportunity.
One of the flaws of passive investing is best illustrated by the experience of an investor who purchases a passive strategy on successive days. If the only change over the two days in the underlying portfolio is that a stock has doubled from day one to day two, with no company specific news to justify this change, the investor allocates twice as much capital into the stock after it has become twice as expensive. This feature of passive strategies pushes them to follow rising prices, thereby driving market inefficiency. It is a process driven by mundane technical - not tangible - fundamentals.
This has the effect of sending passive money flowing into the same assets – the largest stocks gather investment simply by having the largest weights in an index. As an example, the five largest stocks in the FTSE 100 account for more than a quarter, at 24.6%, of the index.1
In our view, this leaves passive strategies at risk of being sucked into bubbles. In the technology boom at the end of the last century, we saw a vast issuance of technology company shares, many of which were of dubious quality. Some firms managed to reach such a size, that they gained entry to the FTSE 100 despite having virtually no revenue. Many such firms endured a share price crash when the dotcom bubble burst.2
In this bubble, Vodafone, at its peak, was on course to represent over 16% of the FTSE 100 after its merger with Mannesman. However, at the stock’s highest point, Vodafone lost more than 75% of its value in just over two years.3 Of course, active managers are not immune from bad calls, but we are firm believers in the ability of detailed research and corporate engagement to weed out weaker firms that may be momentarily lifted by a rising tide.
A new phase for active management
The COVID-19 pandemic has created significant volatility within global markets and has shone a light on the vital role played by active managers in driving the economy. As economies went into lockdown, the pressure drove a surge in fundraisings as companies sought to repair and strengthen their balance sheets, and ultimately take the risk of insolvency off the table. UK-listed businesses have raised approximately £25bn since the start of lockdown in March.4 Without active managers, these fundraisings would almost certainly not have taken place.
As passive funds only track an index, they mostly do not participate in fundraisings; to do so would put them out of sync with their primary role of replicating a market. Once the newly issued shares are included in indices, passive funds then adjust their holdings to reflect the index. Active managers, however, enjoy the opportunity to evaluate fundraising offers and assess the potential value they offer investors ahead of time.
Moreover, we have seen greater stock dispersion – i.e. a wider spread between the top- and bottom-performing stocks – within UK indices. This is common in periods of heightened volatility. As active managers – in contrast to passive strategies - we can take advantage of price volatility. This provides active strategies with the potential to enjoy better returns in such an environment.
In addition, the recent introduction of MiFID II legislation in the European Union, has led to a lower volume and lower quality of research coverage on companies, particularly small caps, which could result in poor market coverage. Here, active managers may benefit from a greater number of undiscovered or underappreciated opportunities through focused strategies and by conducting fundamental research. In short, moments of crisis like that seen in 2020 can create investment opportunities that are simply not open to passive investors.
Adding value through active management
As active managers, we deploy thorough top-down analysis using macroeconomic and microeconomic research to identify themes or trends with long-term growth potential. In addition, we take a bottom-up approach to stock selection through proprietary analysis (both quantitative and qualitative), external research and through hundreds of meetings with UK-listed companies each year. This provides us with the chance to identify potentially attractive opportunities, particularly in small- and mid-cap names, and drive additional alpha.
We believe that periods of turbulence, keenly felt by equity markets during lockdown, could yet return if a second wave emerges and economies struggle to cope. In our view, the unpredictable ebb and flow of the virus, and the likely uneven recovery, will offer a crucial edge to active managers. Coupled with the fact that UK stocks have generally been trading at a 30% discount to their peers5, we feel that now is a good time for active investors to look towards the UK-listed equity market.
1 FTSE Russell, 30 September 2020
2 For example: Baltimore shares near 99% fall, BBC News, 5 July 2001
3 FTSE 100, 3 June 2000 to 7 March 2002
4 Peel Hunt, as at 26 October 2020
3 Morgan Stanley, as at February 2020
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