Institutional investors may need to reconsider current equity valuations and the potential for lower returns over the next 10 years vs. a “cheap” beta approach through passive investing. Balanced 60/40 portfolios with heavy passive allocations will struggle to meet plan objectives going forward as fixed income allocations are likely to generate negative to flat results. Therefore, the ability to source 200-300bps in alpha with a well-crafted, cost-appropriate, high active share strategy may appear more attractive going forward to offset lower capital market assumptions.

We Are in an Alpha World Going Forward

Valuations are currently higher than they’ve been over 90 percent of the time since 1950. History has shown us that when equity valuations are at similar levels, a lower return environment is likely to follow. The broader market appears to be in the sweet spot for stock selection, making more granular stock picking an important proposition to earn total returns to justify the risk budget allocation.

Shiller P/E vs. 10-Yr Forward S&P Total Return (Since 1950)

Why Own the Laggards and Losers?

The appearance of diversification in the S&P 500 is deceiving to passive investors who continue to be focused on tracking error as the primary measure of risk. There has been a significant declining trend in stock-pairwise correlations over the past several years and they are currently approaching 10-year lows. Additionally, return dispersions within the index have been steadily widening, shining more light on the separation between the winners and losers. Currently, the difference between the six-month trailing return for best performing stock compared to the worst performing stock sits above 60 percent, the highest it has been in almost two years. The combination of lower correlations and increased dispersion among returns presents challenges for passive investors who are forced to maintain exposure to the entire index, including the laggards and losers. Conversely, these developments present a potentially favorable environment for high-conviction, active managers to showcase their stock picking skill and generate alpha for investors.

S&P 500 65-Day Correlation
(Last 10 Years)

In addition, we now see an extremely narrow market forming, negating many of the investment benefits of indexing. For example, the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) were the primary drivers of the index return for the first half of the year and have made up 35 percent of the S&P 500 Index return YTD through August. At the sector level, tech had contributed 98 percent of the S&P return at the midway point in the year and has contributed over 50 percent of the S&P 500 YTD return through August. The sector’s weight in the index now has eclipsed the 20 percent level, which has only happened once before during the technology dotcom bubble in 2001.

Anticipate the Alpha Opportunity

The combination of unintended concentration risk to index investors, narrowing of market leadership and late cycle valuation concerns increases the opportunity to harvest single stock alpha. In addition, macro uncertainty and tightening of financial conditions has led to corporate debt levels reaching all-time highs, which could put pressure on cap-ex and stock buybacks. This is likely to create greater disparity between companies and an emphasis on high-quality, well-run businesses with conservative balance sheets becomes increasingly important for investors. Historically, a rising rate environment where tightening increased at an increasing rate was beneficial to active managers.

Outperformance of Active Funds when Interest Rates Increase
(Since 1962)

Take Action: Learn How Westwood’s High-Conviction, Active Approach Can Help You Harvest Single Stock Alpha

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