From Autopilot to Active Pilot: How Investors Can Navigate the Future

In what has so far been a very volatile year for the financial markets, many of my conversations with clients, peers, and allocators across our industry have touched on the role of active management. The passive returns of the US equity market have been at historic levels in recent years (through year-end 2021, the S&P 500 generated annualized returns of 26.1% for 3 years, 18.5% for 5 years, and 16.6% for 10 years versus an average of 9.95% since 1930).

Going forward, I believe that active management will be critical, with investors requiring a broader and more sophisticated set of tools to maneuver through more modest market returns, but also higher levels of volatility, changes in market structure, the explosion in investment data, and the global incorporation of sustainability. Or to put it another way, I think the investment “plane” will have to be switched from autopilot to active pilot, leveraging the best navigation tools available.

Macro-driven volatility and more modest capital market expectations

Macro trends are likely to drive up volatility, as markets feel the effects of:

• The end of “easy money” as central banks hike rates to ward off inflation
• A multiyear deglobalization trend, including the transition from efficient supply chains to resilient supply chains
• Aging demographics in Europe, Japan, and China
• The global government response to income inequality

There will likely be a greater focus on uncorrelated and risk-adjusted returns offered by investment strategies that can complement passive exposures. Hedged returns will likely be important for many investors as well, and, in fact, absolute return and macro strategies are already seeing rising demand. And with capital market expectations, including those of our own Investment Strategy group, signaling a downward adjustment in market returns in coming years, alpha will be more precious.

The blurring of the lines between private and public equities

In the last 20 years, the number of companies in the US private equity universe has grown from less than 2,000 to more than 8,000, while the number of public companies has declined from just over 8,000 to roughly 4,000. Along with this explosive growth, the private equity market has been reshaped by changes in how private companies fund their growth, which has altered the path to the public market (e.g., companies are staying private longer).

These changes in market structure require investors to view the spectrum of public and private companies in new ways. And managers must have the resources to add value for clients, including the deep research needed to understand the entire universe (e.g., how disruptive private fintech companies will impact publicly listed regional banks and money center banks) and invest wisely across privates and publics to seek to maximize returns. Amid these changes, institutional investors are looking to partner with active managers through co-investments in specific opportunities, as well as seeking to invest more capital in thematic idea “top-ups” that reflect key alpha themes in an underlying portfolio.

The blending of art and science in pursuit of investment objectives

We believe asset managers will need to embed data science in every aspect of portfolio management to have an edge. This includes idea generation, portfolio construction, risk management, and investor development. Consider idea generation, for example: Almost 200 members of our investment teams are using alternative data dashboards (e.g., data on credit cards and job openings) to help anticipate company growth, hiring and retention trends, consumer patterns, product changes, etc. And natural language processing (NLP) and machine learning are being used to review large volumes of financial documents in areas such as securitized finance.

Active research and engagement on sustainability

We believe that long-term sustainability themes, such as climate change mitigation and adaptation, for example, are impacting capital market flows. In addition, clients increasingly expect their asset managers to act as long-term fiduciaries by ensuring that capital markets and the companies being invested in are contributing to a sustainable future. Our approach has been to leverage our deep equity, credit, and ESG research and use constructive engagement with companies (over 17,500 meetings annually) on a variety of issues, from science-based climate targets to supply-chain reviews to board diversity. We also have research partnerships with Woodwell Climate Research Center and MIT (along with five asset owners) to help clients bridge the gap between climate science and finance.

The bottom line is that the bar for active management is only going higher. We believe success will require deep global research, a long-term horizon, and an ability to connect dots between fundamental, quant, macro, and technical insights; between private and public markets; and between all of the major asset classes. And research and portfolio management teams will need to be armed with the technology, tools, and science needed to navigate through what we expect will be more volatile skies as they seek to help clients reach their desired destination.