Time to get active: How to make your portfolio healthy in 2023

Markets have started the year on a jubilant note.

However, as we have learned over the last few years, economic and geopolitical shocks are unpredictable and trying to forecast unknowns is a folly.

What we can, however, be more certain of is we are moving to an environment of higher volatility than we have been accustomed to over the past decade.

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As such, we should expect higher return variance both across and within asset classes.

But volatility can be your friend, and so can being active.

Navigating change

There is still much debate over whether active or passive investing provides the best return on investment, with staunch proponents on either side.

There is a place for both in portfolios.

Active management, however, is necessary for ‘price discovery’, without active there can be no passive.

Recognising changing trends and patterns is where active managers can excel, they are able to be agile, adapting and responding to an evolving investment landscape.

The past decade has suited a ‘set-and-forget’ allocation which saw passive strategies accumulate vast flows, and assets under management have now surpassed that of active managers.

Ample liquidity lifted all boats. But we are now at inflection point as we move to a world of higher trend inflation, higher rates, liquidity withdrawal and one of higher volatility.

This will require investors be more selective about the regions, sectors, and individual stocks and bonds they pick, and we believe is an environment more conducive for active management.

Greater dispersion of returns

As passive assets have grown, the more informationally inefficient markets have become.

We can see that evidenced in ‘bubbles’ where valuations of certain stocks and segments of the market reached eye-watering levels as investor flows drove up asset prices.

With central banks suppressing volatility through extraordinary stimulus measures, dispersion of returns fell significantly and fuelled a narrow cohort of stocks to dominate over the past decade.

But as the era of free money comes to an end, and we can longer rely on central banks to bail out markets, this will see the continued unwinding of concentrated positions and drive higher dispersion of returns and increased market breadth.

Company specific factors should reassert themselves, providing an opportunity for skilled active managers to add alpha.

As global markets adapt to the seismic shifts unfolding, it will be a bumpy ride and there will be winners and losers.

Active management enables skilled investors to invest in-depth fundamental research, access company management, integrate ESG and responsible considerations to find the leaders of tomorrow.

Notably they play an important role in ensuring efficient and rational allocation of capital.

Managing downside risk

Criticisms of active management are valid, with research showing the average active strategy fails to consistently outperform.

The success of passive over the past two decades, however, has come amid one of the greatest bull markets ever.

When you buy a fund tracking an index, you never beat that index, but you are strapped in for the ride, both up and down.

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The bear market that enveloped markets in 2022 has become decidedly more difficult for passive – with the inherent shortcoming of the inability to manage risk, particularly in falling or volatile markets – leaving holders more exposed to risk than they might have realised.

With a focus on quality companies with strong balance sheets and durable growth, skilled active management is as much about dodging the losers as backing the winners and exploiting market inefficiencies.

As recession risks still loom on the horizon and worries about weaker earnings as margin pressures bite – an active approach is better at managing downside risk.

Skilled active management can therefore enhance returns over the long run – but focus should be on managers who have strong research capabilities, a long-time horizon, a proven and repeatable process alongside reasonable fees.

Changing market leadership 

We have seen significant style rotation as the market regime has shifted.

From the growth orientated FAANGs to pandemic stay-at-home winners to the rotation to value stocks amid a rates shock.

This has impacted entire sectors and industries.

It may be prudent to balance value and growth styles in portfolios and focus on opportunities that may transcend these categorisations – and focus on individual companies on the right side of change.

From those with durable earnings and pricing power, to identifying winners from secular themes such as ageing demographics, digitisation, decarbonisation and deglobalisation.

A changing landscape means we cannot just extrapolate past trends and relationships, valuations both absolute and relative will matter more, and an adaptable forward-looking approach will be critical to navigate the path ahead.

The question is not about whether active or passive is better.

Over the past 30 years there have been four distinct cycles in the US.

During the tech-fuelled bull markets from 1995-1999 and the QE-driven markets of 2010-2021 passive dominated.

From 1990-1994 and 2000-2009, when markets reached an inflection point active outperformed. So rather, which does better in different market cycles.

Passive investing is based on the shape of markets today and may struggle during periods of transition as indices are largely poorly positioned for structural change.

Anticipating change and the need for agility is a time when active management merits consideration.

Perhaps, now is the time to get active.

Ritu Vohora is investment specialist, capital markets, at T. Rowe Price

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