In Brief

• There are a variety of tools available to build diversified portfolios depending on the outcome an investor is trying to achieve
• From 2000-2010, developed market (DM) returns were flat, while emerging market (EM) equities were a bright spot
• The following decade saw the U.S. handily outperform the rest of the world, which coincided with strong flows into passive investment products
• Having a solid framework for identifying active strategies is essential, and should focus on alpha generation, batting average, and upside/downside capture ratios
• Going forward, successful asset allocators will employ a combination of active and passive strategies – there is no silver bullet

Part of being a good builder is knowing what tools to use. Is something being demolished? Get a sawzall and a sledge hammer. Putting joints together? Use a miter bit. Redoing a bathroom? Better have the tile saw ready to go. The bottom line is that using the right tools at the right time can make or break a project.

The same can be said for investing. Sometimes beta is your friend, but sometimes it is your foe. On the other hand, certain factors work better in some environments than in others. And when it comes to inefficient markets, an active approach can add a lot of value.

The sharp drawdown and quick, uninterrupted, bounce back in equity markets from the March 23rd lows caught quite a few investors off-guard. As a result, more and more clients are asking how they should be thinking about equites going forward, particularly in light of elevated valuations. Furthermore, it is increasingly clear that COVID has created winners and losers, as some companies have seen significant revisions to earnings over the past few months, while others have seen estimates hold up a bit better. For example, technology and healthcare companies have seen structural tailwinds reinforced, but might lag the more cyclical parts of the market against a backdrop of improving economic growth, rising inflation expectations and a falling dollar. Meanwhile, elevated leverage across the small cap spectrum may prove to be an issue if revenues fail to rebound in the coming quarters.

Given this backdrop, as well as the fact that we are at the beginning of a new cycle, it is a good time for investors to look at their toolkits and make sure they have what they need. By understanding how and when to leverage both active and passive investment strategies, investors can build portfolios that are better equipped to navigate the coming years. Nobody builds a house using just one tool; portfolio construction should not be any different.

How did we get here?

The last two decades have seen two very different market environments in the U.S. and around the world. In the U.S., the 2000s marked one of the most challenging periods in history for the equity market; the decade started off with the Technology bubble bursting, and ended with the Global Financial Crisis. This led the S&P 500 to deliver a negative total return over this 10-year period. The following decade, however, saw a complete reversal, as U.S. equities experienced the longest bull market in history and the S&P 500 delivered above average returns with below average levels of volatility (Exhibit 1).

Exhibit 1: Index Returns and Risk (2000-2019)

Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management.

Looking outside the U.S., international developed markets were challenged in the 2000s as well, generating average annual returns of ~1% over the 10 year period. That said, emerging market equities were the standout, delivering a return of ~10% on the back of a China-led commodity boom. While U.S. equity markets saw a strong rebound in performance during the following decade, both international developed and emerging markets lagged, delivering average annual returns of between 4% - 5.5%. The one constant across all regions, however, was a decline in volatility following the Global Financial Crisis (Exhibit 1).

Against this backdrop, flows into active and passive equity strategies saw a drastic shift, especially in the U.S. where performance improved. In the 2000s, active and passive strategies saw strong inflows as both U.S. and international developed markets were challenged. In the 2010s, however, the trend changed; active U.S. equity strategies saw tremendous net outflows while passive strategies saw an almost identical amount of net inflows. In international markets, both passive and active strategies saw inflows, contrasting the experience in the U.S. (Exhibit 2). This shift towards passive has been most pronounced in the core of the style box, with Large Blend, Foreign Large Blend and Diversified Emerging Markets driving the majority of inflows.

Exhibit 2: Equity Net Flows ($B):

U.S. Equity includes: Large, Mid, Small: Value, Blend, Growth categories
International Equity includes: Foreign Large Blend, Foreign Large Value, Foreign Large Growth & Diversified Emerging Markets categories

Source: Simfund, J.P. Morgan Asset Management.

The strength of U.S. equity returns in the 2010s and lack of significant market pullbacks has accelerated the shift toward passive strategies. Broadly, active U.S. equity strategies have found it more difficult to outperform low cost, passive strategies in an environment of above average returns and below average volatility. .  International markets have seen a less dramatic shift to passive as they tend to be less efficient, and potentially providing a greater opportunity for active to outperform.

The first quarter of 2020 displayed a sharp market reversal. The S&P 500 ended down -19.6% over the first three months of the year, which included a peak-to-trough drawdown of 34%. International markets continued to underperform U.S. equities, with both international developed and emerging markets down over -20% (Exhibit 3).

Exhibit 3: 2020 Q1 Returns and JPMorgan LTCMAs

Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management.

Looking forward, however, the environment for equities is changing.  International equities returns are expected to improve, and the time of double-digit U.S. equity returns against a backdrop of low volatility may be a thing of the past.  According to J.P. Morgan’s 2020 Long Term Capital Market Assumptions, U.S. large cap equity returns are projected to be 5.6% over the next 10-15 years (Exhibit 3). This would be a very different experience than the 13%+ returns seen over the prior decade, and clients may want to consider active management as one way of potentially boosting expected returns and/or managing risk.

With the sharp equity market reversal and the first bear market in over a decade, let’s review how U.S. equity active strategies performed (Exhibit 4). Highlights listed below:

• Four out of ten active U.S. Equity strategies outperformed their Morningstar category index
• Outperforming active U.S. Equity strategies delivered strong average excess performance, 2.64% to 3.88%, with mid and small cap strategies showing the strongest results

Exhibit 4: 2020 Q1: U.S. Equity Active Manager Outperformance

Source: Morningstar, J.P. Morgan Asset Management.

Given lingering uncertainty around the path to recovery, the virus itself, the Presidential election, and U.S./China relations, it seems reasonable to expect volatility will remain elevated. In light of this, as well as the results shown above, it is clear that finding the right active manager can add value for clients and help keep clients invested over time.

A framework for identifying active strategies

There has been clear shift from active to passive equity investments over the last decade, but active management is not dead. Rather, having a simple, repeatable framework for evaluating actively managed strategies is essential, and as simple as knowing your ABC’s.

Alpha: Is your investment delivering excess returns over the benchmark or equivalent passive ETF?

Batting average: Is your investment consistently outperforming over time?

Capture ratios: Is your investment focused on balancing risk to both capture upside and minimize downside?

Our analysis suggests that investors should look for managers that can deliver on the ABCs over time. In other words, we look for managers who are able to generate positive excess returns over the benchmark, have a batting average of at least 50%, and maintain a positive spread between their up/down capture ratios.

Exhibit 5: U.S. Large Cap Value analysis using the ABC’s

Source: Morningstar, J.P. Morgan Asset Management.

As an example, we look at two funds in the U.S. Large Value Morningstar category.  The first is an active mutual fund that meets the suggested framework for the ABCs, and the second is a traditional passive ETF tracking the benchmark.  In an equity category that’s been challenging to navigate, applying the framework described above could have identified a strategy that delivered strong returns relative to the passive, market cap weighted ETF, with less volatility, more consistency, and a better upside/downside capture ratio.

So where to from here?

With COVID-19 case growth re-accelerating across parts of the U.S., the potential distribution of outcomes remains quite wide. We expect that more winners and losers will be created in the months and years to come, and successfully navigating this environment will require a blend of both macro and micro thinking. In other words, investors will need to recognize broad-based trends, and simultaneously identify those investments that stand to either struggle or prosper based on these developments.

Investors should not wed themselves to a single approach – you certainly wouldn’t use a hammer to screw in a light fixture. Although correlations have risen, dispersion has increased as well, suggesting that while in aggregate things are still moving together, there is opportunity for active managers to add value. It is also important to recognize the efficiency of different markets when figuring out how to optimize a blend of active and passive investment strategies. Finally, picking the right manager matters, and having a framework for evaluating investment options will remain of the utmost importance. At the end of the day, plumbers typically aren’t very good at electrical wiring, and you would never ask paver to paint the house.

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