Volatility Is Back—And That’s a Good Thing for Active Management

Apr 20, 2018
3 min read
Volatility Is Back—And That’s a Good Thing for Active Management
Richard A. Brink, CFA| Market Strategist—Client Group
Walt Czaicki, CFA | Senior Investment Strategist—Equities
Scott Krauthamer, CFA, CAIA| Global Head—Product Management & Strategy

It’s been a rocky start to 2018 for equity markets globally—volatility has returned with a bang and February saw the first 10% market correction in a while. So, why are active managers smiling?

It’s hardly breaking news that active management struggled mightily in the years since the global financial crisis, intensifying the questions about the effectiveness of active management and accelerating the surge in investment flows into passive equity strategies. Part of the problem for active was structural. A crowded field, developed over many years of strong markets and inflows, grew a large industry of active managers fighting for alpha.

At the same time, active managers drew closer to the benchmark, limiting the opportunity to outperform. However, based on active share and tracking error, the 20% of managers who were the most active beat their benchmarks substantially.

Equally important, the relative performance of active managers hasn’t been uniform across environments. There were tough times—the buildup to the tech bubble in the late 1990s and the QE-driven period after the global financial crisis. Across those two periods, only 21% of active managers outperformed (Display). But in all other time periods, 50% beat the benchmark.

How Do Active Managers Fare in Beta Trades…and Outside Them?

Large-Cap Blend Managers Beating S&P 500, Rolling Three Years

How Do Active Managers Fare in Beta Trades…and Outside Them?

From December 31, 1992, through December 31, 2016
Historical analysis does not guarantee future results. An investor cannot invest in an index.
Represents the percent of mutual funds in the US Large Blend Morningstar category outperforming the S&P 500 on a rolling threeyear basis with a monthly step The data include active mutual funds only.
Source: Bloomberg and Morningstar Direct

This performance pattern underscores one of the most important determinants of active-management success: Are we in a beta trade or not?

Active management is challenged during big beta trades. The great rising tides of these markets make individual boats less important—even when they’re better boats. In these environments, dispersion among individual stocks is weak. As dispersion falls, the potential for alpha falls—and vice versa.

The linchpin of this relationship between beta and alpha is volatility—higher volatility translates to higher dispersion, which works in favor of active managers. But it also tends to create more challenged market conditions (Display). This landscape leaves a lot of space for active managers to add value.

Higher Volatility Increases Security Dispersion

Monthly Stock Dispersion* vs. Level of VIX (Percent)

Higher Volatility Increases Security Dispersion

As of May 31, 2016
Historical analysis does not guarantee future results. An investor cannot invest in an index.
*Dispersion is cross-sectional standard deviation of monthly returns.
†Median monthly return of the S&P 500
Source: Bloomberg, Chicago Board Options Exchange, eVestment, MSCI, S&P and AllianceBernstein (AB)

Clearly, volatility is up so far in 2018: the S&P 500 Index experienced more 1% daily moves in the first quarter than it did in all of 2017. There have been plenty of worries to stir the pot further: the end of quantitative easing, rising interest rates, inflation pressures and geopolitical concerns that include populism versus globalism (the possible US-China trade war is a prominent example).

We’ve seen the return of the sell-off, too. In February, the S&P 500 endured its first 10% correction in quite a while. When markets tumble—or even when they’re less than stellar—active management offers the potential to maneuver and avoid trouble spots, playing defense to help protect against the downside. Passive management is locked into a benchmark, so it doesn’t offer that ability.

Just as the wave of growth in active management caused structural problems, the surge in passive investing is creating challenges, too. With the number of indices exceeding seven figures and a wave of money and a herd of passive vehicles chasing so few stocks, the risks of crowded trades breaking are probably as high as they’ve ever been. And so is the potential damage.

The active versus passive debate, for all intents and purposes, is over. Today, it’s about active and passive. Both approaches play useful roles in a portfolio. But given the expectations for markets ahead, we think overlooking the potential in active management as volatility rises could be a mistake.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.


About the Authors

Richard A. Brink is a Senior Vice President and Market Strategist in the Client Group. Previously, he served as a managing director in the Alternatives and Multi-Asset Group. Prior to that role, Brink was a senior portfolio manager in Fixed Income, and before that an investment director for fixed-income investments within the Global Retail Investments Group. Before joining AB in 2004, he was senior product manager at the Dreyfus Corporation, covering both retail and institutional fixed-income offerings. Brink was previously a senior trainer, dealing primarily with the design and delivery of product training to financial advisors and mutual fund sales representatives. He holds a BS in applied mathematics and economics from Stony Brook University, and is a CFA charterholder. Location: New York

Walt Czaicki serves as a Senior Vice President and Senior Investment Strategist for Equities at AB. He rejoined the firm in 2015 and has been in the investment-management industry since 1986. Czaicki's roles have ranged from a fundamental equity research analyst and portfolio manager to chief investment officer. Prior to rejoining AB, he worked on the buy side for a Regions Financial predecessor organization, as well as at Commerce Trust Company and Bank of America. Czaicki holds a BSBA in finance and an MBA, both from Saint Louis University. He is a CFA charterholder. Location: Dallas

Scott Krauthamer is a Senior Vice President and Global Head of Product Management & Strategy, overseeing AB's global investment products across the firm's equity, fixed income and multi-asset strategies. Prior to joining the firm, he held a variety of investment and product-management roles at Legg Mason, U.S. Trust, Bank of America and J.P. Morgan Private Bank. Krauthamer started his career as an analyst at J.P. Morgan in 1998, and his financial-services experience spans investment-management, quantitative analysis, marketing and business development. He holds a BS in finance and management information systems from the State University of New York, Albany, and is a CFA charterholder and a CAIA designee. Location: Nashville