Market Volatility Creates Bigger Role for Active Managers

Active strategies may play a larger role in investors’ portfolios as increases in macro and market volatility widen the gap between top- and bottom-quartile managers.

BlackRock’s report, Sourcing alpha in the new regime, assessed how greater volatility, uncertainty and divergence in market performance may impact investment portfolios. Rising interest rates have left the predicted returns on static asset allocations unattractive to many investors.

In 2023, 58% of fund selectors reported that their actively managed investments outperformed passive, according to the 2024 Natixis Global Fund Selector Outlook Survey. Additionally, 63% predicted active investments will outperform passive again in 2024 and 75% said active investments will be essential to finding alpha in 2024.

BlackRock’s report also said investors capable of identifying top-performing managers can expect to see greater rewards in the current market compared to previous years. However, finding managers that consistently generate alpha requires significant resources and expertise, both upfront and on an ongoing basis.

Qualitative research is one of the most useful tools for identifying high-performing asset managers, but analyzing the data requires an understanding of an investment manager’s strategy and competitive advantages compared to their peers.

The report said: “With less clarity among market participants on the path forward, we see more scope for skilled managers to outperform. Yet the risks associated with, and the importance of avoiding, underperforming managers are also more meaningful.”

Identifying Alpha

Alpha is defined as the excess return above a portfolio’s benchmark that cannot be explained by broader market, macro and/or style factors. It is often regarded as the return derived from a manager's skill alone.

While alpha is dependent on an investment team’s skill, the ability to derive these excess returns is also reliant on market efficiency. During periods of increased volatility and uncertainty, market inefficiency provides skilled managers with the opportunity to capitalize on a wider array of mispricing.

BlackRock's report noted that US equities annualized 15.7% over the five-year period ending December 31, 2023. However, it forecasted US equities to return 4.0% per annum over the next five years.

As a result, assuming a consistent alpha stream of 1.5% above the market return over both five-year periods, it said a hypothetical active manager’s alpha contribution would jump from just 8.7% of total returns in the most recent period to 27.3% in the lower return environment.

However, with active management comes higher fees from managers, and high-performing managers will have ample leverage to negotiate fee arrangements. Managing the costs of these fees is a critical aspect of allocating more capital to alpha.

AI-Powered Active Management

Ensemble Active Management (EAM) is a new approach to asset management built on critical artificial intelligence (AI) technologies and employs a stock-selection approach mirroring other industries’ best practices for conducting complex decision-making.

EAM was first introduced in 2018 and EAM portfolios launched later that year. While better-performing funds are preferred to EAM portfolios, Turing Technology’s study, Ensemble Active Management — AI’s Transformation of Active Management, found that superior fund selection skills are not needed to properly power EAM portfolios, potentially providing a lower cost alternative for investors.

While AI could provide a helping hand, the stakes are high for investors to make the right choices against a volatile and unpredictable backdrop. Fears of a recession have declined but economic growth could still disappoint optimistic investors and decision-makers should remain cautious and prioritize diversification to protect client outcomes.