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Economic Conditions May Make Active Management More Appealing

Advisors who are advocates for active management have a lot of adversity. The news media is full of stories that focus on the small number of portfolio managers who outperform their benchmarks. At the same time, some actively managed funds that capture high ratings from Morningstar frequently see their ratings decline over time as their investment performance suffers from regression to the means.

Many pundits also complain that fees associated with active management can erode returns. Yet, advisors who favor active management have a unique opportunity to capture clients by explaining how current economic and market conditions are making it easier for active managers to add value.

In the process of discussing the timely events that are making active management more appealing, advisors can demonstrate their strong knowledge of capital markets and how economic factors are an important consideration when assessing if active managers should be included in an investment program. Simply put, in the early phases of an economic recovery, such as the first few years after the “Great Recession” optimism among investors often resulted in a high correlation of the performance of stocks as most companies benefited from growing business opportunities.

It’s not just investor optimism, however, that caused correlations to be high. Indeed, during a rising tide of a fresh economic recovery, it’s easy for companies to grow their earnings, especially when earnings are compared to periods during prior recessions. In such an environment, it can be difficult for leading companies to grow earnings at faster rates than their peers, so investors may not have significant reasons to favor one company over another.

For active managers, high correlations among stock returns make it harder to pick stocks that will outperform the broader market. As recoveries continue, however, it becomes harder for companies to grow their earnings. During such times, therefore, companies that lead their industries with compelling products or services are likely to differentiate themselves by producing earnings that exceed their peers. Stocks of those companies, generally speaking, are likely to outperform stocks of other companies as strong earnings can support valuations, dividend payments and stock buybacks. This trend is illustrated in a recent Morgan Stanley research paper

It that shows how active managers have been increasingly outperforming since approximately 2012. The paper also shows that a lower percentage of active managers outperformed during the early portion of the economic recovery. For advisors who favor active management, the mature phase of the ongoing economic recovery is an attractive marketing opportunity.

When meeting with prospects, advisors should be prepared to explain why stock performance correlations decline during later phases of economic recoveries and how active managers that use research-driven investment strategies have potential to find companies that will outperform the broader equity market.

As part of their presentations, advisors should illustrate how even incremental returns in excess of broad indexes such as the S&P 500 over the long term can play a big role in helping grow retirement savings. Advisors should be able to customize their illustrations based on prospects’ savings rates, investment time horizons and long-term goals.

Advisors should also be prepared to address prospects’ objections to active management. For example, advisors should provide examples of active managers who over the long term have outperformed their benchmarks gross of fees. Advisors may also want to show how leading active managers have been able to deliver attractive returns on a risk adjusted basis.

Advisors that favor portfolios that use both passive and active management products may also want to illustrate how the actively managed assets within their proposed portfolios are more likely to outperform during the current phase of the ongoing economic recovery.

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