Since the financial crisis, investors have enjoyed generally benign conditions, with subdued volatility and strong markets - but active equity managers have remained under pressure. Yet this should not be surprising; history has shown a strong pattern of counter-cyclicality in manager excess returns relative to the equity market.
In this study, we take a close look at the relationship between equity market conditions (defined by market returns, volatility, and dispersion) and active equity manager results. Focusing on the US large cap space, we analyze over twenty years of manager and market data to determine which set of conditions are associated with more or less favorable results for active equity managers. Our key conclusions:
- Conditions that are conducive for active equity management have not been in place for several years, but investors should bear in mind that conditions do shift.
- There is a strong pattern of counter-cyclicality in active manager returns, with stronger excess returns generated in weak markets.
- Dispersion (the variation across stock returns at a given point in time) can also play an important role in outperformance, particularly for fundamental managers.
- In general, we find active management to be most successful in periods of “differentiated decline,” when market returns are low and dispersion is high.
- Quantitative managers are less sensitive to market conditions; investors seeking stability and consistency in outperformance across market environments should consider a combination of quantitative strategies across styles.
- Fundamental managers tend to generate higher excess returns over time; investors that are tolerant of cycles and focused on long-term outperformance should focus on a combination of more highly active, fundamental managers in growth and value.
Our objective is to provide investors with a better understanding of the relative importance of changing market conditions and the need to bear in mind that they can, and do, shift. There is a market for passive and active management, not one versus the other. PGIM’s focus is on helping long-term investors understand the dynamics and the fit of active management in their portfolios.