Diversification, Active Management in Focus Amid Shifting Landscape
By Lisette Cooper, PhD, Managing Partner and CIO of Athena Capital Advisors
To many observers, the election results extended an eight-year ascent for US equities. Now that the so-called “sugar high” seems to be receding, however, discerning fund managers are starting to look a little more closely at the longer term impact. In recent meetings with several prominent hedge fund managers, it is clear there remains precious little in the way of consensus around what it will all mean for the economy over the long haul, which in and of itself will likely lend to a more volatile environment for investors. What is self evident is that even if stocks assume a less certain path, stock pickers will be well positioned amid the transition from a market driven by monetary actions to one far more influenced by fiscal policy. Said another way, as the future becomes less predictable, discretionary hedge fund managers like their odds against passive-index strategies or quant-driven systematic strategies that rely on backward-looking data.
To be sure, most of the fund managers that we’ve met with over the past few weeks are optimistic about the markets in the near term. Most, though, don’t see the recent equity rally necessarily as an extension of the past eight years; rather, they see the recent shifts within the capital markets as being reflective of an inflection point in which significant long-term trends will likely be upended. These views are in line with our own research and current thinking and we agree that the new dynamics materializing today represent a turning point in a number of ways.
To wit, the regulatory agenda of the past administration is being replaced with a policy of repeal; interest rates, after being slashed for eight years, are on the rise; corporate taxes in the U.S., among the highest in the world, appear set to decline; and an era of globalization is being threatened by new walls and a protectionist ethos that will almost certainly curb growth. Meanwhile, zero certainty exists around the timing of any of these developments and there are no assurances either that they’ll definitively come to pass. When one also considers a not-too-distant future that promises leapfrogging, disruptive technology that will reshape industries and the labor market writ large, it should be clear that this extended stretch of high correlations could quickly erode.
But make no mistake, discretionary fund managers are viewing these winds of change in a positive light, at least as it relates to their strategies and the value proposition they can provide as active managers. Indeed, amid all this change, distinct winners and losers will emerge. Those that can couple rigor around risk management, with a high degree of decisiveness to spot and decisively act upon emerging trends should stand out in this shifting landscape.
Take, for instance, the about face on regulations. Less than a month into Donald Trump’s presidency, he had already issued 18 executive actions and orders. Among those was a mandate in which for every new rule proposed, at least two existing regulations need to be identified for elimination. He also initiated actions that could lead to the repeal of rules affecting healthcare, manufacturing, and financial services, while implementing a freeze on all regulations sent to or published in the federal register prior to his inauguration. These actions, while applauded by many in the business community, don’t necessarily lend to the long-term stability of the markets. In fact, there is plenty of academic literature suggesting that deregulation led to both the 2002 market crash and the 2008 financial crisis. This certainly is not to suggest a new crisis will emerge, but unexpected consequences will always result from initiatives so broad in scope.
The likelihood for rising interest rates also promises to upset the balance of the market’s sustained and consistent trajectory. Financials clearly benefit, but after that, the higher cost of capital and changing market dynamics will affect each industry differently. The bond proxy stocks, for instance, could see a rotation out sectors such as consumer staples or regulated utilities.
Even something as seemingly black and white as tax reform presents a degree of uncertainty. For instance, would tax cuts in some areas be funded by tax increases in others? And what would be the longer term impact if trillions of dollars are added to the federal debt? While we see that monetary stimulus is about to be replaced by fiscal stimulus in the U.S., it remains to be seen how corporations would deploy their tax savings. If some are emboldened to spend more on capital projects, it could translate into improved growth forecasts. Alternatively, others may simply buy back more stock, which would be a catalyst for equities in the short term but unlikely to help promote jobs and further the new President’s agenda.
All of these questions, though, are top of mind for discretionary managers today. Conversely, this is why we’re anticipating rougher waters ahead for passive strategies or backward-looking, factor-based quant strategies that lack foresight into change at this scale. Moreover, in this ephemeral period of relative contentment -- with the VIX still near historic lows -- discretionary managers are able to price in incredibly cheap hedges to manage tail-risk volatility. This opens the door for some really ambitious thematic plays that could help hedge fund managers regain some of their past glory.
In any event, our conversations with fund managers over the past few weeks amplify the importance of maintaining a diversified portfolio. While there are opportunities to suss out new trends emerging from the current political and economic environment, there is also enough uncertainty to require some level of continued diversification. These discussions have also underscored the importance of due diligence in selecting managers that not only understand the risks but see the opportunity presented by inflection points such as what we’re encountering today.
Lisette Cooper, PhD, is Managing Partner and CIO of Athena Capital Advisors