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16 Mar 2023
Long live active management
Is your investment portfolio positioned for the royal ascent of tomorrow’s market leaders?
As the nation prepares to celebrate the upcoming coronation of King Charles III, I’ve naturally been thinking about leaders and transitions of power.
Within some established systems, such as the British monarchy, these transitions are predetermined and immutable. In others, notably the financial markets, they are anything but. Leaders are regularly and unceremoniously unseated from office and their successors can come seemingly from nowhere.
Predicting future leaders is notoriously difficult
The financial markets have a habit of defying expectations. In the 1970s, for example, a group of large-cap stocks labelled the “nifty fifty” were widely believed to be safe bets for long-term performance and, as such, were included in most equity portfolios. During the 1973-1974 stock market crash, these stocks lost 90% of their value, and commodities became king.
Similarly, in the 1990s, information technology stocks appeared invincible, leading the charge with a 1690% return, before the dot-com bubble burst and leadership was handed to energy.
This might seem inevitable, but it feels like investors aren’t talking about it very much this cycle. A recent example is Cathie Wood’s flagship ARKK innovation fund, which became something of a figurehead for the post-Covid bull market. After a roaring 2020, where it returned 152.52% (against 16.26% for the S&P 500), large losses followed in 2021 (-23.38%) and 2022 (-66.97%)1. However, its year to date performance for 2023 of 37.16%2 suggests that there are plenty of market participants who think that this time it really is different, and will therefore be the same.
The age-old debate: Active or Passive investing?
In the pursuit of profit, investors have just two choices:
- Actively try and identify the leader of the next market cycle, or
- Passively buy the market and trust that, over time, economic growth will deliver returns above inflation
Both approaches are easier said than done. On the one hand, we all tend to overstate our ability to forecast, due to inherent cognitive biases such as hindsight bias (after-the-fact identification of signposts of otherwise unpredictable events) and recency bias (overemphasis of the importance of recent events).
On the other hand, it is actually more difficult than you might think to passively gain exposure to “the” market. How does one pick which market to invest in? What are the opportunity costs of doing so? Very soon, one is compelled to start making small but significant active decisions.
Passive funds have been enjoying a moment in the sun
Nevertheless, passive funds have skyrocketed in popularity over the past decade, with inflows into exchange traded funds (ETFs), i.e. low-cost funds that mirror a specific index or sector, growing from $200bn in 2013 to over $600bn in 20213. That period has undeniably offered a boon to passive investors, with the S&P 500 returning 362.57% over the 10 years preceding 2022, or almost 14% per year4. However, it’s questionable how long this good luck can continue.
The economic tides are poised to turn
In a recent memo entitled “Sea Change”, famed investor Howard Marks noted that “we may be in the midst of a third [sea change]” in his 53-year career. He described how investors have benefited over the last 40 years from “the tailwind generated by the massive drop in interest rates” and how, with interest rates now starting to climb, the next economic cycle could look very different.
The macroeconomic shift he predicts would create a far more challenging environment for passive funds to keep pace with inflation and could tip the balance in favour of active investors.
So, where should active investors place their capital to profit from the next bull market?
Having observed the acute unpredictability that is inherent to the financial markets, it would be bold of me to pinpoint a specific stock or sector that is destined to be the leader of the next cycle.
As an active investor, however, I will note that themes such as the future of healthcare, artificial intelligence, and the energy transition are hotly tipped in investment circles. It seems inevitable that some areas within these will fundamentally change the way we live, and the investor who can position accordingly looks likely to do well.
As much as renewable energy technology has developed recently, when all inputs are considered, renewable sources lag massively behind nuclear and fossil fuels in terms of the energy return on energy invested (EROEI) according to research published by the Hedge Fund Goehring & Rozencwajg5. Nuclear power has an EROEI of around 100:1, that is for every unit of energy input, it generates 100 back. Oil & natural gas are around 30:1, and wind & solar, after adjusting for intermittency and redundancy, are much lower at 3.5:1.
Storage of course is a key problem to be solved - a self-sufficient renewable grid requires energy storage solutions to provide power when the wind isn’t blowing and the sun not shining. Then there is potential in hydrogen, and small-scale nuclear power generation, or even the holy grail of nuclear fusion. Uranium also has the potential to prove lucrative for some.
The human touch can prevail
My faith in active investment was recently reaffirmed by a surprising source. On Radio 4’s Today programme, the actor Charles Dance read a sonnet written by the AI chatbot, ChatGPT. While I am no literary critic, even I could tell that, though the structure of a sonnet was present, there was still something missing. In poetry, at least, the human touch is not yet replaceable.
I believe the same can be said about active management. In an environment where returns are likely to be harder to come by, and where certain sectors and technologies are going to have a profound impact on our lives, a discerning active investor has the potential to significantly outperform the wider market.
1 Morningstar; Factset
2 Morningstar, as of 3/2/23
3 US only equity ETFs; Morningstar and Wells Fargo as reported in Bloomberg, John Authers Points of Return 26/1/23
5 Goehring & Rozencwajg, Q4 2021 commentary
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The information contained in this article does not constitute a personal recommendation and the investment or investment services referred to may not be suitable for all investors. Any opinion or estimate expressed in this publication is Investec Wealth & Investment’s current opinion as of the date of this article and is subject to change without notice. The value of investments and any income from them is not guaranteed and may go down as well as up; you may get back less than the amount invested. Past performance is not an indication of future performance.