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Asset Allocator

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How DFMs' active vs passive models stack up; The recession questions that won't go away

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Closing the gap

This time last year, market activity was looking rather doomy for DFMs. A year on and steadier conditions reign supreme. And while moves below the surface have created their own difficulties for active strategies looking to prove themselves, the tide has started to turn for the discretionary fund manager community.

We noted in summer that DFMs' passive-based portfolios had, on the whole, surged ahead of their active counterparts over the past 12 months. Now, more than a year since markets began their Q4 sell-off, signs have emerged of a shift in that balance. The chart below provides the latest data on how passive models have performance compared with active equivalents:

Conventional balanced portfolios still tend to lag their passive-based equivalents over a one-year period. But compare these figures with those recorded in July, and the difference is clear. Although the sample size is a little smaller this time round, it's apparent that the degree of passive outperformance has shrunk. 

Three active portfolios have outperformed their passive counterparts, and, for two other firms, there was nothing between their active and passive offerings' performance. On average, a passive balanced portfolio has beaten its active equivalent by around 0.45 percentage points, down from 0.65 last time.

What’s also notable is the much tighter range of outcomes on display. In our last analysis the biggest active laggard trailed its passive equivalent by more than 4 percentage points, with the greatest active outperformance standing at more than 6 per cent. This time, the gap either way never exceeds 3 percentage points.

What’s behind the change? Active managers may simply have opted to ride the rally in both risk assets and diversifiers. Equally, conviction positions - we've observed some firms scaling back the number of portfolio holdings in a bid to focus on their best ideas - may also have helped active models close the gap. Whatever the reason, the improving performance is some cause for some optimism in cost-conscious times.

Recession research

Heading into the new decade, the big imponderable for investors is still whether or not the US is heading into a recession. The longer the expansion continues, the more likely that scenario becomes. But the plain sailing of the past few weeks has dampened fears in the short-term.

In contrast to 2018, this year October was notable for a return of animal spirits rather than a rise in macro worries. The monetary policy environment is rather different this time, too. And with election season approaching, the onus is on the US to make some quick progress on its trade disputes.

Yet working out the likelihood of a recession is still something of a finger in the air exercise. The New York Fed’s model, based on the yield curve alone, now puts the odds of a recession in the next 12 months at just 29 per cent, according to Northern Trust. Allianz GI, in contrast, says its structural economic model puts the probability at 87 per cent.

The latter’s cyclical and financial market indicators are much less alarming, and that emphasises what some wealth managers suspect is a growing disconnect between markets and the underlying economy. 

Per data from Bespoke Invest, the S&P has just gone 30 days without a back-to-back decline for only the second time in two decades (the streak ended overnight). That suggests investors are still relatively relaxed about equity market valuations - bond proxies aside.

It’s a similar story for high-yield debt, which has an equally two-speed feel to it at the moment. Northern Trust is among those content to remain overweight the asset class, in the belief that widening spreads are mostly due to the energy sector rather than anything more structural.

But it’s not just markets versus the underlying economy. As Premier Miton Investors’ Anthony Rayner points out, the divergence between US business confidence and US consumer confidence is at a record high: business confidence is the lowest for a decade, whereas consumers feel better than they have done for several years. Working out how divergent data starts to converge in 2020 remains the biggest challenge facing wealth managers for the months ahead.

Closet clampdown

Yesterday the FCA revealed one of the most egregious pieces of industry bad behaviour in recent memory. In 2011 Henderson decided to cut back on the amount of active management applied to two of its funds - and it told institutional investors about the move, and cut their fees, but didn't do so for retail buyers. That state of affairs persisted for almost five years.

Henderson has been fined £1.9m as a result, a move that has been viewed as a sign that the watchdog is continuing to turn more attention to the issue of closet trackers. 

Are such practices still occurring in 2019? The regulator's forthcoming 'value for money' assessments should, in theory, make it harder for fund managers to mask this kind of behaviour in future.

But there's a loophole - as Ignites Europe pointed out earlier this week, those running Ucits funds domiciled in Ireland or Luxembourg aren't obliged to produce these documents. That's not an issue for wealth firms whose own research capabilities can easily spot closet trackers and the like. Nonetheless, it raises the prospect that closet trackers might continue to harm to the investment industry's reputation in years to come.

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