Active or passive management? The winner is … the active

A skilled active manager can add value in all economic cycles and markets. But which market segments are most attractive? The State Street Global Advisors standpoint

In the match between active and passive management, the first is the winner. This is the opinion of State Street Global Advisors.
“In our view, a skilled active manager can add value in all economic cycles and markets”, said SSGA in the report titled Where and When to Go Active. The true skill in active management is the ability to deliver improved risk-adjusted investment outcomes through proprietary insight.
Active management has a favored place in many markets, regardless of the economic cycle, and, given persistent behavioral biases and market frictions. “We believe there are opportunities for astute investors to generate alpha – said the managers – Indeed, with growing interest in active quantitative equity management, investors clearly still see an important role for active investing”.
In any case, even if a skilled active manager can add value in all economic cycles and markets, it turns out that active management as a whole has tended to perform better in certain economic periods, namely, “when stock correlation is low, dispersion is high and interest rates are increasing, or, some of the very conditions we appear to be facing now”, the managers added.

Which market segments are most attractive for active managers?
For active managers, inefficiency can be a good thing. “Less efficient markets go hand in hand with mispricings that can provide more opportunity for active managers to generate outperformance – the report explained – But inefficiency alone may not be sufficient”. Inefficient markets tend to be less liquid, with higher transaction costs, where trading is not as fluid and mispricings are more common. “In most cases, these conditions spring from two sources – answered SSGA – Irrational human error and market frictions”. In the first case, investors tend, for example, to naively extrapolate the past too far into the future, to excessively focus on certain information and to be overly confident or overly fearful of losses. In the second case, we must not forget that despite the vast improvements in information technology, we do not operate in a frictionless market. Information is not instantaneously available to everyone, and market participants aren’t always able to act on the available information in an uninhibited fashion. Investors with the wherewithal to obtain and process more pricing-relevant information can glean unpriced insights that aren’t readily available to others. So, “to identify markets where either or both of these forces come into play, investors can seek markets with lower levels of analyst coverage”, the SSGA experts said.
Then, there are other ways. “Investors can also focus on markets with greater performance dispersion between the best and worst performers (where pricing opinions are less likely to hover around a mean level) – said the managers – Another key variable is the nature of a market’s investor base. Markets with a heavy retail skew — the China A share domestic stock market is a prime example — tend to exhibit more fickle inflows and outflows,prompting more inefficiency and thus mispricings”.