Active vs. Passive: My Recent Appearance on Asset.TV

Check out my appearance on Asset.TV with Shannon Rosic. We discuss the state of the debate on ACTIVE v. PASSIVE management and trends in wealth management.

 

On the panel are:

  • Scott Krauthamer, CFA – Global Head of Equity Product Management & Strategy of AllianceBerstein
  • David Hillmeyer, CFA – Senior Portfolio Manager of Fixed Income Products of Delaware Funds by Macquarie
  • Frazer Rice – Managing Director of Wilmington Trust, N.A

Scott and David had lively comments and it was great fun to work with Shannon.

Here is the transcript of the panel:

Shannon Rosic: For the past decade everyone was making money in the market. Recent market volatility signals the good times are over, can stock pickers now beat their benchmarks? Volatility may have rattled investors’ nerves during a rocky first quarter for markets. But did those with their assets in the hands of an active manager, sleep better at night? Short answer is yes. February’s equity market correction gave us a prime example of what happens when too many investors are pouring too much money into a passive trade that falls apart. It’s hardly breaking news that active management has struggled since the global financial crisis and tends to find the questions about the effectiveness of active management and accelerating the surge in investment flows into passive equity strategies. So perhaps we need to start beating the passive versus active argument to death and ask which strategy can deliver more attractive risk adjusted returns to investors. I am joined by three experts who will give compelling cases for active management. So, gentlemen, welcome to Masterclass. So, Scott, I want to start with you and just give a brief introduction in your area of expertise and we will just go down the line.

Scott Krauthamer: Scott Krauthamer, I head up our Equity Global Product, Management and Strategy Team at Alliance Bernstein where we have approximately 150 billion in active equity strategies.

Shannon Rosic: Great. David.

David Hillmeyer: I’m David Hillmeyer, I’m a Senior Portfolio Manager on the Multisector Portfolios for the Delaware Funds by Macquarie.

Shannon Rosic: Great. Frazer.

Frazer Rice: Right, Shannon, I’m Frazer Rice, I’m a Managing Director at Wilmington Trust. I help to manage high net worth, ultra-high net worth and endowment and foundation portfolios.

Shannon Rosic: Great, perfect. So, Scott, I actually want to start with you. Set the stage for us. Can you share a little bit of history of how we got where we are today and with active management?

Scott Krauthamer: Sure. I mean the story goes back a number of decades. But if you think back to the early 80s, all the way from the early 80s through to late 1990s, the market was just fantastic, returning about 17% per year, active management was thriving. At that same time, we saw a huge run of the number of people that were joining the active management industry, where we saw about a 50% increase. What started to happen though post 2000 and the internet bubble was obviously a turn of events led by the technology bubble, which then was further emphasized again during the global financial crisis. So, most peoples’ assets today lived through two major crises. So, it’s not a surprise to me at all that many people have said, “I give up, let me just go passive, because active didn’t deliver what they should.” We think that that’s actually a little bit counterproductive, especially given the environment that we think we’re moving into. But if you think back to what was really taking place and what expedited that was you tended to see people chasing the returns and enjoying it. So, it was kind of self-fulfilling. What ended up happening from an asset management industry is they were getting very happy and very fat, enjoying what was very high fees for a number of years. However, what ended up happening was a lot of those big funds just started to hide behind the benchmark.

And so, they lowered their active share, in fact, active share as a measure of how different you are from the benchmark, really went from the high 80s all the way down to the 60s for most active managers. That’s really a bad thing for investors if they’re paying active fees. Why are you hiding behind a benchmark? And I think we’re at a point now where so much money has poured into passive that we’re at almost an inflection point. And a lot of money is being left on the table, given the market dynamics, and what we see is the next 10 years of a much better environment for active managers.

Shannon Rosic: And, David, talk to us a little bit about the current market environment. You know, why does an active management strategy make sense right now?

David Hillmeyer: Well, probably the best way to think about it is if you think where we’ve come from over the last 10 years as an example, and the unprecedented monetary policies that we’ve experienced in the marketplace and the significant amount of liquidity that that’s injected into the system. And I think that it’s fair to acknowledge that there are consequences that comes with those types of policies. And some would argue that maybe it’s come home to roost now and that we’re not really facing a period of time where the liquidity and the Central Banks starting to exit markets, could actually have dramatic impacts on market outcomes. And that’s one of probably the main reasons why investors, particularly today should be thinking about active management, because typically investors invest in a fixed income portfolio to kind of dampen or reduce volatility, offset other risks that are in their portfolio. The fact is that in today’s environment when you look at the overall construction of indices, they’re very different from where they were just 10 years ago.

And a great example would be just taking the Bloomberg Barclays Ag as an example. In the last 10 years the interest rate sensitivity of that index has almost doubled. And what I mean by that is that if you get a 1% change in rates, about eight years ago you would have experienced about a 3½% price move, today it’s almost double at over 6% price move for that same 1% move in rates. And the composite has changed dramatically. Treasuries going into the financial crisis were just over 20% of the index, it’s nearing 40% today. A very different risk profile for investors today, that they need to be thinking about those considerations because the outcomes can be very different. And active management is going to give the flexibility, the tools to address those changing indices.

Shannon Rosic: So in your opinion then is active management dead? According to these gentlemen it seems to be well and good and alive.

Frazer Rice: I don’t think active management’s dead at all. I think that under most circumstances there’s going to be a place for active management in any portfolio, especially for those managers who beat their benchmark over a long period of time and in a reasonable fee environment. The more important issue, I think, for most clients is making sure that their asset allocation decisions are correct and done with thoughtfulness ahead of time, making sure that you’re in the correct asset classes and then making sure that you understand what your income needs are and what your appetite for risk is. That’s the important decision to be made.

Shannon Rosic: Absolutely. And, David, let’s take a look at, you know, multisector, domestic and overseas asset classes. Paint the picture for me right now.

David Hillmeyer: Well, let me go back to that Central Bank thing again because one of the consequences of Central Bank activity for the last 10 years is very low yields. And there’s still trillions of dollars of debt out there that are trading with negative yields, which is completely counterintuitive. So that you actually have to pay somebody to lend them money under that scenario, which it makes zero sense. And it shows you the dislocations that are in the market as a result of what we’ve gone through the last 10 years. That’s why thinking about a portfolio from a multisector standpoint are looking at a larger opportunity set to try to find opportunities where bonds aren’t providing negative yields as an example. I mean, take for instance, if you are an investor in the European market and the Pan Euro Ag Index, for example, still doesn’t even yield 1%, if they need more income to be able to service their liabilities as an example, what do they do? Well, some examples, they could look at other markets. And that’s something that’s been going on.

Capital has been flowing around the world trying to find the most yield, the most liquidity that they can find in order to offset the risks in their own home markets. And investors are looking at it from the perspective of not only buying bonds in other currencies, but then are making, overlaying a currency decision on that. So, if I buy that bond, what does it look like if I bring it back to my home currency, what will my investors be earning if I do that? What are the risks if I choose not to do that? Those are the types of decisions that we’re having to make in this new world environment where capital is moving all around the world. We’re challenged by low yields globally. We need to be thinking about the opportunity set on a much broader basis, rather than just a confined benchmark, as an example.

Shannon Rosic: And you mentioned that we’re in this low yield environment, what challenges do investors have then?

David Hillmeyer: Well, one of the things I think one of the outcomes of this low yield environment where Central Bank involvement has been relatively speaking low in volatility. An interesting statistic is that if you look at the VIX, which is a measure of volatility that many investors are familiar with, you look at the time period for the 26 years going back from, to 1990 to 2016, believe it or not the VIX had just nine instances when it was below 10, a lower number means lower volatility, 26 years at less than 10 times. 2017, when we’re in a very low volatility type environment, the VIX actually was below 10 for more than 50 days. And we transitioned into 2018 and that continued for the first seven or eight days of the year, and we’ve had a reset higher in volatility. Volatility is going to challenge us, I think, for the balance of the year, Central Bank policies are changing, adjusting risk premiums higher. Investors should be demanding more for what they own and making sure that they’re making the best relative value decisions in a world where we got very accustomed to low volatility, with that resetting higher, we need to be getting paid for that volatility.

Shannon Rosic: And, Scott, you know, volatility isn’t always a bad thing, it can actually may be a good thing for an active manager, right.

Scott Krauthamer: No, I completely agree with David in the sense that a lot of this artificial easing has created this kind of perfect environment. And if you think about last year, it was, we’d call like a perfect year, there were no months where the S&P was negative, that hasn’t happened in decades. The second point is just form a daily trading perspective of the market, there were zero days where the market traded by more than 2% in either direction. This year we have already seen eight of those days. So, we think the new norm is going to be volatility is back. Most people get kind of scared off, especially from an investor standpoint. I would say we as active managers actually look at that as an opportunity. It’s the volatility in the market that actually provides us the ability to trade and to find opportunities. If the market was just on a straight upward trajectory with no volatility the beta trade or just buying into the market is usually fine and adding value or adding alpha on top of that is really hard to do. The volatility creates dispersion across the stocks and creates an opportunity for us to actually find winners and avoid the losers. So, we’re welcoming to the volatility, now again from an investor standpoint, we have to have some, you know, more challenging conversations. But from an ability to add alpha this is welcome news. And I think we’ve already started to see active managers just broadly in the US already start, you know, more than 50% so far, active managers to beat their benchmark year to date. So, we think that that’s … we’re welcoming it and we think that that’s a sign of the new times.

Shannon Rosic: Sure. And, Frazer, you know, how do, you know, active managers kind of quell those investor fears then, because we are in this volatile state right now?

Frazer Rice: Well, I think the best way to do it is by outperforming. One of the big things that we try to do when we’re picking managers and which I think is really the difficult part is trying to understand which managers have a process, which have a set of ownership in the management that eat their own home cooking in many ways is understanding that they have a process in place that’s able to take advantage of the volatile conditions that we’re seeing, or take advantage of opportunities that they’re able to dig up, maybe in times that aren’t volatile, but through their own spadework they’re able to go through and say, “Jeeze, you know, we think this works or we should be avoiding that.” The key then is communication from the managers and saying, “You know, we’re seeing volatility as a theme, that’s something we can take advantage of and this is something that we have a track record of dealing with over time.” The difficulty of course is that over the last eight plus years it hasn’t been very volatile. So many managers have difficulty articulating that, or at least a success rate around that for that period of time. But then that comes to groups like Wilmington and others who go in and analyze managers and try to go back as far as possible to see which managers have succeeded in rockier times.

Shannon Rosic: So at the end of the day how should investors really get their arms around this whole active versus debate with the current state of things?

Frazer Rice: Well, I think it goes back to my earlier statement where if you go back and say, if you have your asset allocation in place and you’re happy with that and you understand that investment returns are going to be in a certain set of guardrails for yourself. Then I think you go back and say, “Is the active manager going to be able to provide performance on an after tax, after fee and after inflation,” we use that in sort of a broader sense, may not have applied in the fixed income world. But build those criteria around it so that when you’re making those selections in the active management space they’re informed selections. And we got back to the concept of active share, that’s a good criteria or at least one metric that’s a good way to analyze whether a manager is taking risks and doing things that they’re paid to do as it relates to either making a concentrated bet or staying within their style box and able to take advantage of the opportunities that they’re seeing.

Shannon Rosic:And, Scott, so in your opinion, where can active managers really add value with the current market conditions?

Scott Krauthamer: Well, I think you’ve got to look at it twofold, like historically active managers have done much better in challenged markets, which over the past few years haven’t really been that challenged. So, in what we call markets where the S&P was up more than 10%, only about 35-40% of managers have historically outperformed. However, if you look at markets where it’s been kind of flat to down, those are actual markets where active management has more than proven its worth. And I think we’re going to be in a more challenged environment moving forward. So as active managers I think we have to look for pockets of alpha, and I think those can be in some of the small cap names. But I think more importantly, I think it needs to be with high conviction managers. And by that, I mean to, you know, to David’s point, it’s got to be about high active share. You have to look different from the benchmark otherwise there’s no chance for you to beat the benchmark. If you can do that you can, and you should get paid for it. And I think that’s going to be important for this next leg is proving where you can find those opportunities. And to us, again, back to the volatility point, and the dispersion that we think is going to be created from it, we think that the market is really starting to open up.

Shannon Rosic: And, David, same question for you, where are active managers adding value?

David Hillmeyer:Well, I think the best way to think about it, just to quantify it is the Morningstar Intermediate Bond category, largest category within the Morningstar fixed income universe, over 300 strategies I think are referenced there. If you look at it over a 10-year time horizon, so that’s going to include periods of high volatility and even low volatility like we’ve been experiencing in 2017 as an example. If you rank the Bloomberg Barclays Ag Index in that universe, it ranks 84th%. So that means that more than three-quarters of fixed income managers are outperforming those that are actively managed. So that’s a pretty powerful statement around active management. And the reason being is that indices can be very limiting in terms of your opportunity set. They don’t necessarily represent the fixed income universe that investors might actually choose to buy. And you know, if you’re looking at opportunities, for instance, if you’re looking to try to diversify away interest rate risk in your portfolio there are things that you can do by looking at high yield, which has a lower correlation to changes in interest rates, that’s a fixed rate asset class but has a lower correlation. Perhaps you’re more concerned about rising rates and you want floating rate exposure. You know, as an investor you can choose to allocate more of your money to bank loans as an example, so you get the floating rate exposure.

So, there are a lot of different opportunities that you can do and entertain outside of a traditional benchmark that can actually, one, enhance return by adding income, giving you the diversification benefits and better risk adjusted returns overall. And I don’t think that investors should really fear and shouldn’t … fees are important, it’s an important consideration. But I think that the risk management aspect of a fixed income portfolio and the complexity and the different levers that you can pull within fixed income. I think in fairness to all investors, you know, when you’re making your decisions, look at the risks that you’re getting in a passive type strategy and look at the risks that you’re getting in an active strategy and balance those and find the risk rewards and what you specifically as an investor are looking for. You might determine that active management might be more appropriate for you.

Frazer Rice:And to amplify David’s point, I think that the choice of a benchmark is important. I think we’re using the word in a very sort of broad sense, and that benchmarks are obvious for many people, and many times they’re not. And I go back to the fixed income comment, certainly in the municipal world there are tens of thousands of issues, and no one index can encapsulate that well. And so, you end up possibly missing whole asset classes as you’re trying to deal with constructing portfolio municipal securities if that’s part of your asset allocation. I would take it back even further and to say that in order to get your asset allocation right, I think there’s got to be a pretty robust discussion around the benchmarks that you’re using so that you don’t run into these types of issues. And that when you’re making an active versus passive bet within the various benchmarks that you’re working with that you understand where you think you’re going to add value and maybe where it might make more sense to be passive on an after-fee basis on that front.

Shannon Rosic: So, Scott there’s this argument that investors want the best of both worlds, you know, actively managed, you know, management with passive like fees. But while that sounds great, are folks really losing on the opportunity then to outperform?

Scott Krauthamer: We think we’ve got to look at it in kind of two buckets. The first is by definition people think that by going passive they haven’t made a decision, but really, they have. And their decision is that they believe that bigger companies deserve more of their capital. Why does that work like that? It’s because most indices are cap weighted, so it means bigger companies make up a bigger part of the index. So as money pours in, like what we’ve seen over the past decade, as a trillion dollar plus has poured into it, all of that capital is going to go to the highest weighting companies first, making them even bigger. So, they’ve made an active decision that big companies are essentially better companies, which I would say needs to be kind of evaluated. The second point is if you couple that with a more high active or high, you know, conviction manager, you can allow that manager to make those decisions on behalf of the investors to say, “You know what, maybe the biggest companies aren’t always the best. Maybe there are some companies that don’t deserve that capital.” So, I think when investors want the best of both worlds they want active management alpha at really low fees. And I think the industry does need to evolve to kind of balance some of those factors out. But I think right now if many investors, you know, are kind of combining their passive with some active, I would say right now it’s probably best to tilt it a little bit more towards the active given the environment that we’re in today.

Shannon Rosic: So all that being said then, have you really had to reconsider your business model due to this shift?

Scott Krauthamer: I think we have and I think others have had to do so as well, just the amount of money that’s leaving active and chasing that kind of passive trend, it’s been astronomical. And at some point, in the near future, we’ve never seen it yet, but at some point, that might slow down or potentially even reverse. We don’t know what’s going to happen, but I will tell you, it will cause even more disruption. So how we’ve had to do it is we first had to kind of really be honest about the alpha that we can provide and where we can provide it. And so, we use a number of tools in-house to really understand how much of the returns of each portfolio are from beta, how much are from factors and how much are truly kind of idiosyncratic or purely stock specific. And I think we need to understand where we have conviction, that’s worth paying for. And so, having an honest dialog with our clients and saying, “Look, here are some of our high conviction strategies. Many of them are high conviction from a downside protection, some are high conviction from a concentration level.” I think it really comes down to what can you actually deliver what is worth paying for. And the industry is evolving because of that and I think we need to be in front of that. And so, we’ve had a lot of success in having those conversations and really avoiding what I think is likely to continue to get hurt, which are these closet indexers, or active managers that are really, you know, closet indexers with high fees. I think that is a trend that will continue to get demolished.

Shannon Rosic: Sure. And, David, what about at Delaware Funds, you know, have you guys had to kind of shift your business models as well to kind of appeal to these new investor needs?

David Hillmeyer: I would agree with Scott in that we definitely are well aware of what’s going on in the competitive environment within our marketplace. And it’s shifting and shifting quickly actually on many different fronts. When it comes to active management though it’s almost as though clients are demanding more if they’re going to be paying for something above a passive type fee. We recognize that aspect. And one of the things that we need to do from a business perspective that we are aggressively focused on is making sure that we are more than just delivering performance for our clients. What we’re hypersensitive to is trying to work with the clients, fully engage with the clients and make sure that we are trying to address their needs beyond just performance, so being more solutions based, and delivering outcomes that are above and beyond just managing their money. A lot of clients out there, with the regulatory environment having shifted the way it has over the last 10 years, there’s been a new onus that’s been put upon them. How can we engage and help them work though some of those challenges? What can we be doing with our business to make their business easier? So, becoming more of a very client centric type business model in an environment where we still are committed to an active management belief. You know, at the Delaware Funds, just in terms of the size and scope of our business, it’s still easy to express the teams’ views from an active perspective. When you get a significant asset base it can be somewhat challenging at times to be able to really build portfolios bond by bond, you know, idea by idea. We’re still able to do that so we can still believe that we can be very competitive in the active space, but we need to be addressing more than just performance for our clients.

Shannon Rosic: And, Frazer, what about you guys, how are you constructing your portfolios right now?

Frazer Rice: Well, unquestionably the environment active versus passive has an impact on the business model of what we do. In many ways we feel like we’re active managers for peoples’ personal lives. And so, what we’re trying to do is help them on an after-tax basis, and then where investment performance is important, that’s one component that we’re able to help them achieve their goals. So how do we construct portfolios? Certainly, go back to the asset allocation component, make sure that income needs are met, that risk is taken into account, that the goals are articulated, and that the money is invested accordingly so the likelihood of success in meeting those goals is maximized.
What we try to do then is just make sure that we monitor those types of situations as much as possible and as events warrant, whether in an individual’s case you have, birth, marriage, divorce, death, sale of business, all the different ways where a life intervenes and can otherwise change the characterization of what wealth is supposed to do for the client, to make sure that we’re on top of it. And so as active and management components fit into that, we try to make sure that when the investment performance where we can enhance that, that we construct the portfolios in a way that we aren’t taking too much risk where if we choose one manager who is active and we choose another manager who is active, that we don’t have overlap in the sense that both managers are making the same huge bet on Google or something like that. We try to make sure that we analyze exactly what each manager is doing, why they’re good at it and how it fits in with the rest of the asset allocation so that we’re not taking what’s good or bad with each of the different asset managers, combining them in a way that overconcentrates risk and then frustrates the other goals that we’re trying to advise upon.

Shannon Rosic:And we touched on this a little bit earlier, but in your opinion where do you see active managers really thriving? Obviously, you know, Scott, mentioned, you know, you’re welcoming kind of this volatile environment. But in all of your opinions, where do active managers stand out?

Frazer Rice: Well, I think if I’m starting first, I would say certainly in the less efficient asset classes, where an active manager has some sort of edge, either informationally or through skill. So, if you get into the alternative spaces, certainly in private equity where someone has … a manager has a particular expertise in either bringing back leverage buyout situation or maybe a venture situation where they are able to see trends before they actually happen and find the managers or the executive teams that are able to implement that. If you’ve got an edge on that, that’s an active management component where an index is not going to be able to help you, I would say. As you move up into the efficient asset classes, I’d say in areas which aren’t well covered by the Wall Street industrial complex. Whether it’s international or maybe in the smaller company area where people have particular expertise and the managers are able to execute on that and deliver returns outside of an index, that’s the low hanging fruit where active management can sometimes add value in an obvious way. And then as you move up the ladder in the larger asset classes in the equity side of things, I’d say those people who have site specific expertise in their particular industries, sometimes that can overcome what I’d say sort of an information deluge and you’re able to overcome that component. On the fixed income side of things, I think there’s a lot of room for active management expertise to shine for a lot of the reasons we talked about before. In many ways I think the indices are faulty. And so, number one, I think you do well when you pick your benchmark well in the fixed income environment. And then I think the people who are able to really spend a lot of calories well in terms of credit analysis can add a lot of value in those types of portfolios.

Shannon Rosic: And, David, your thoughts too on the fixed income space, where are they adding value and thriving?

David Hillmeyer: Well, when it comes to the fixed income space I think what we hear from our clients a lot is the need for income. We’re in an income starved world with yields as low as they are today. And that’s where active management can actually help our clients by considering things, other asset classes that bring diversification benefits, that bring additional income into the portfolio to help people that are relying on income as an example. Income in a portfolio traditionally helped offset volatility, right. When you look at the return profile of a fixed income portfolio, a significant amount of that return is coming from the income piece, it’s not coming from price, unlike in the equity market for example where you get movements in the price and the dividend is a smaller percent of the overall return, it’s not the same in fixed. So, where we can find solutions to help address that, by looking at asset classes that offer more yield, that’s one thing that we’re looking to do for our clients. The other thing is, when you’re looking or you’re evaluating for an active manager just ask yourself, you know, a couple of questions, for example, how does the portfolio manager think about risk as it pertains to interest rates, because since that’s such a topical issue, get to know your manager, get to understand what service you’re buying. What are you paying for in order to understand their philosophy and their process and that goes a long way?

Also, how do they take advantage of opportunities in the credit markets, the credit markets are significantly large. And there is an opportunity set there, how do they think about it from a fundamental perspective? What makes them want to move down in the capital structure in a particular credit to source more income in an environment where income is so challenged and difficult to find. And the last point I think I’d raise is how are they going to just drive that competitive income relative to the benchmark. Traditionally, fixed income generated enough income that it was a meaningful amount of cash flow. Today in an environment where the Aggregate Index for instance is only a 3.4% yield, it’s still pretty skinny, even though we’ve seen yields push a little higher more recently. How can we deliver that competitive income? Those are all important questions to be asking your active manager. The example is it’s a partnership, work with your active manager, make sure that they’re delivering the needs and meeting your needs as your investor.

Shannon Rosic:And, Scott, your final thoughts on the markets.

Scott Krauthamer: I would agree with both Frazer and David. I would say that in the equity market specifically in the less efficient areas, in the international emerging markets in small caps, I think there it’s very clear that active has done well over time net of fees. I think in the parts of the US market there’s kind of this push and pull and the parts that haven’t delivered have been those overly diversified strategies. I think if you can find the high conviction or strategies with call it 60 or fewer stocks, higher active share, they have been able to add value and I think that will likely continue over time.

Shannon Rosic: And, David, you mentioned interest rates a little bit. And they’re obviously on the rise, you know, who can potentially be the big winners from rising rates and who loses?

David Hillmeyer: So when you think about who’s going to be the big winners and who’s going to be the big losers in this type of environment, I think that that example illustrates the price sensitivity of a fixed income portfolio today. So, the reality is, is that what you want to be able to do is have the flexibility to, if you don’t want to own that 30-year bond, what else can I choose on the maturity spectrum where I could source less interest rate sensitivity. And as you shorten up that maturity, so from that 30-year down to all the way to something that’s a very short maturity, the sensitivity around interest rates changes. So, in active management you have that flexibility to be able to move up and down that maturity spectrum. In an environment, if you believe that yields are going higher, you don’t want to own that longer dated bond. If you think that yields are actually going to move lower, you do want to move out that maturity spectrum. So, in an environment where yields are potentially moving higher, more floating rate type exposure, more bank loan type exposure, portfolios that have the flexibility to source floating rate, bonds is going to be an advantage, it’s going to be an advantage for them relative. And to the fixed rate market, in an index like the Barclays Ag again, the Bloomberg Barclays Ag, they don’t have floating rate notes in it. So, if you’re indexing to that you don’t have the flexibility to be able to say, “I’m going to take that interest rate sensitivity out of my portfolio and buy a floating rate instrument.”

Frazer Rice To add something to that, one way we think about it at Wilmington, especially in the municipal space, for those people who are looking at income, we try to think about it in terms of understanding what an increase in interest rates is going to do to a particular portfolio. So, when clients are looking at it and saying, “Jeeze, you know, short, long, intermediate, what do you think here?” What we try to do is demonstrate that if there’s a 25-basis point rise in rates, if there’s a 50-basis point rise in rates, and over a short period of time or a long period of time, what is the impact of that particular sort of data point going to have on the portfolio itself? If they start seeing red brackets in the return and clients look at that and say, “You know, that’s more pain than I’m willing to withstand.” That helps to make them an informed decision as we’re advising them where to position themselves on the fixed income side, which I think is pretty close to what you’re talking about, David. It’s just we’re looking at it from a slightly broader aspect and trying to meet the income need in the environment where we’re getting the client to help us make the decision with them.

Scott Krauthamer:On the equity front most people are only looking at interest rates and their impact to their bonds. I think we’re in a really interesting part of the cycle where rate increases are actually going to have an impact on the equity markets. And I don’t think many people are paying attention to it today. In fact, we looked at the leverage or the net debt to equity of companies in the US and other parts of the world and already year to date we’ve seen a huge divergence between the performance of stocks that have just a minor or no debt versus those that have a lot of debt. And the reason why it matters now is we are likely in a cycle of rate increases. So, companies that have a lot of debt on their books, it’s going to cost them more to service that over time. That’s a bad thing for those companies. And I don’t think many people have paid attention to it because it didn’t matter. Over the past 10 years rates have really just been a tailwind. Well, now they could turn into a headwind. And to kind of turn it back from an active management standpoint being able to understand from a, you know, a quality bias, like where are the companies that can navigate the storm and where are the ones that are going to have further pressure. And I think in this environment, those that have a lot of debt are probably underestimating the impact to rising interest rates.

Frazer Rice: To add onto that point, I think one interesting thing about the interest rate cycle, first of all I think it’s very difficult to predict where interest rates are doing. We were, and I think, many of us saying the same things that interest rates had to go up three years, five years ago and it didn’t really happen. We’re really seeing the first indicia of that in a long period of time. Another aspect where active management, I think, helps is in the fact that we’re coming off of a generational slide in interest rates. There’s a lot of expertise out there that doesn’t exist in terms of how to deal with a rising interest rate environment. So those people who are able to select managers and to select themes and have expertise and performance around that where they have been able to operate in a rising interest rate environment, that’s something to look out for as you’re picking active managers, whether it’s in equities or in fixed income.

Shannon Rosic: Sure. And, Scott, coming back to you and, you know, you mentioned weathering storms. You know, in February we saw the S&P endure its first 10% correction, you know, in quite a while. So how did active managers and Alliance Bernstein really weather that storm?

Scott Krauthamer: Active managers on the whole did okay. I think it really depends on the style and kind of what the purpose is of each portfolio. We did extremely well, we had about 80% of our strategies outperform during the downturn which we were quite proud of. And we actually saw even more significant outperformance in some of our growth strategies, where, you know, most people think growth is risky. We actually think if you have a quality bias within your growth mandate you can actually hold up quite well during a down storm. So, we held up very well, we were very proud of it and making sure we share that news with our clients is critical.

Shannon Rosic:And, David, similar question and maybe explain a little bit how active management may mitigate risk specifically when it comes to fixed income investing in this environment.

David Hillmeyer: The benefit of diversification, I think that that’s one of the best ways to think about it. So, as an example, interest rate risk, credit risk, none of its created equal, right. And that there are asset classes that are more sensitive to rising rates. There are asset classes that are more sensitive to lowering interest rates. Even if you start to drill down and look at individual holdings in a portfolio, there are credits that are more sensitive to interest rates moving up or down. So, making sure that we’re taking steps to mitigate those risks in those types of environments and analyze the entire landscape meaning there might be issues in Washington that are causing geopolitical risks to increase, that will have a material impact on market pricing. As active managers, what steps are we taking to address those concerns that are happening. For instance, there’s a lot of talk around the Iran deal and how that can impact energy. How are we positioning a portfolio around the energy and the issues potentially that could arise as a result of Iran. Those are all steps that we need to be thinking about and taking from an active perspective to try to make sure that we are delivering the best risk adjusted returns for our clients and not putting them in a position where we are trying to source returns and not getting paid for that risk.

Shannon Rosic: And obviously, Frazer, you know, active managers have to wear a lot of hats it seems like. But what are some qualitative indicators of a good asset manager?

Frazer Rice: Well, we went through the quantitative ones a little bit. They have to be able to perform well. So, if they underperform all the time you’re not really going to bother giving them a chance. You want it to be at a fee that’s somewhat reasonable for what they’re doing. And we talked about active share, you want them to be making concentrated bets so that they’re not benchmark huggers and something that you can get essentially for free nowadays through the passive markets. I would say from a qualitative perspective, and we touched on it briefly before, one of the major aspects that we think is important when sort of selecting active managers, we want to make sure that the management is aligned with the goal of the active management group. Are they invested themselves in the portfolios that they’re generating? I would also say that to some extent, is there a business succession component in place? Are the employees, owners of the better prize, are they part of it? So that you’re not really contingent on just one person. And if they get hit by a bus suddenly the whole strategy could be a problem.

I’d go so far as to say maybe some of the other components really besides track record and so on, just an overall feel in a process that something that’s able to be articulated and repeated over time. And to the extent that they can demonstrate a culture of idea generation, I think that helps because ultimately the passive markets are going to catch up with you at some point. And so, if you’ve got something that’s novel now, in a year or two or five years the factors will catch up and, in a sense, make your edge passive. So, you’ve got to have something in place with your active management group so that you’ve got a group of people who are coming up with new ideas so that when the market catches up with you, you have something, you have an edge that’s repeatable going forward.

Shannon Rosic: So I want to kind of debunk some misconceptions that you hear about active management, especially when it comes to the last bull market, you know, Scott, what are your thoughts?

Scott Krauthamer: Well, I think the biggest misconception is that active management can’t work. And I think the biggest issue with that is it’s just painting this broad brushstroke of every active manager is created equal. And similar to not every benchmark is created equal, not every active manager is created equal. So, I think that the first myth is that active can’t outperform. I do think it is challenging in different parts of the market are a little bit easier, a little bit tougher. But I think the environment that most people have lived in over the past 10 years has been this perfect environment where you had multiples expanding, the market going up. That is probably the perfect storm against active managers. We think when you’re in a more normalized environment where PEs are flat and potentially coming down, and maybe the market is flat to potentially down, that’s when active really shines. So, I think that’s probably one of the biggest misconceptions. I would say the second is that all vehicles are created equal, right. I think fees are definitely a big concern for most. And, you know, we’ve looked at ourselves and said, “Maybe there’s a better way.” So, we’ve started to work on some newer strategies where we can have a flexible approach where if we deliver alpha we get paid and the investor gets paid. If we give you a benchmark like return, guess what, you pay ETF like fees. Things like that are really going to change the asset management industry and I think it’s going to be for the better.

Shannon Rosic: And, David, another misconception is that the passive versus active discussion is the same for fixed income fund managers as it is for equity managers, is there any truth to that?

David Hillmeyer: Passive investing is a little counterintuitive when you think about it from a fixed perspective. Scott was walking us through an example earlier when he was talking about market caps, you know, and as the market caps get bigger, you own more of that particular company. In fixed income, since ours is debt driven that means you own more and more of a company that is adding more and more debt which is somewhat counterintuitive, sure there are differences between, you know, a high-quality company that might actually be significant in size, so it might have a significant amount of debt outstanding. But the flipside is that you might just be investing more and putting … lending money, because that’s what you’re doing in the fixed income market, to companies that are overleveraged. And as they add more debt, you as an investor keep giving them more money. It’s a little bit counterintuitive. And the reason why that matters, use the 2008, 2009-time period where we saw significant volatility in credit. And you saw downgrades by rating agencies. You saw companies that were in investment grade fall into high yield, so they crossed over. And passive type strategies would have solved those securities. They would have solved them, in many instances, back then 20 or 30 or 40 points below where they would if they would hold them to maturity as an example.
In an actively managed fund, assuming that your client guidelines permit, you might elect based upon your analysis to continue to hold those securities. Ironically those were the best performing securities the following two years, because … so those investors that made an active decision to continue to hold those were rewarded for that. And they had the flexibility to be able to express a view, do we want to add more or whatever the case. But point being is that you can see when periods of volatility, particularly when it pertains like the 08 crisis where bonds were migrating through the credit spectrum for selling in a passive type strategy as it drops out of their index, actually might have been the best opportunity to acquire the security rather than sell it.

Shannon Rosic: And, Frazer, you know, what’s one misconception that you often have to debunk in your experience?

Scott Krauthamer: I’ll give you two. I think the first one is that the term ETF equals passive, I think a lot of times people equate the vehicle or the structure of the vehicle with passive investment. And sometimes when people are new to the investment world or even if they’re sophisticated and have thought one thing or the other, we have to debunk that a little bit and say, “You can be very active and be in an ETF vehicle. And you can be very passive and be in a different vehicle.” And so many times it’s a nomenclature thing and it seems silly. But it’s a good thing to remind ourselves about the, you know, sometimes words matter and that you could be keeping misconception upon misconception if you don’t get those things straight earlier on. I think the other one is that just because you’re in a passive index, that’s sort of buttressing off of Scott’s point a little bit, but that’s an active decision. And I look at that and sort of put that in the framework that not all, or I’d say all passive vehicles have a different flavor to them. The Russell 1000 is going to be different from the S&P 500. The [inaudible] All World Index is going to be different from the EFA. And so even as your asset allocating across different indexes, and maybe you’re going the passive approach in dealing with it, those are active decisions that you’re making when you’re choosing an index. And to not drill in a little bit and understand where those indexes play and how they are implemented, you’re going to be making concentrated bets where you didn’t really know you were making one.

Shannon Rosic: And there’s this ongoing debate about which market is the leading indicator of performance. Is it the equity market or is it the fixed income markets? So, don’t bust out the fists yet, but, David, I’d love to start with you.

David Hillmeyer: Fixed income, you know, kind of the big joke I guess for fixed income guys or investors is that we’re the pessimists in the room, right. We’re the ones that always approach the markets, that the glass is half empty rather than half full. The equity guys will be the half full guys, right. They’re the ones that are always perky. But the reality is, is that in fixed income there are a lot of different signs that you can actually observe that are warning signs or good leading indicators. Fixed income markets got the, for instance, the great financial crisis right well before the equity markets did, just by the way they’re approaching it and they’re being pessimistic.

I mean the reality is, and I think I said earlier about the majority of the return in a fixed income portfolio comes from income. And if that income is interrupted in any way through a principle haircut or a default or something like that, that is very difficult as a fixed income manager to dig your way out of that hole. We just don’t get the price swings like you would in other asset classes. So, we approach that with that as the general understanding. So fixed income is a great indicator. And I also think that when you think about, because it kind of parallels the market is the short end of the marketplace, the cash funding markets, are the great place to continue to watch potential signs of stress, whether that be the CP markets or whether that be the Libor markets or anything like that. For instance, earlier this year when the front end of the Libor rates were moving higher there was a question being asked, “Is this something that is more systemic in nature? Is this idiosyncratic?” Meaning is it just specific to one or two things. At least up to this point it looks as though it might be just specific to a significant amount of treasury bill issuance at the beginning of the year and also some potential impacts as a result of Tax Reform. But follow the front end of the curve, it’s pretty telling, it sends a pretty powerful message. If you see the front end of the curve coming under pressure that could be a pretty strong signal that you should be reducing risk.

Frazer Rice: Was this sort of the area where in the money market world in 2008 when they started breaking the book that, to me that was the sign, you know, this time it’s different, there is something systemic going on here. Is that an example of that?

David Hillmeyer: The example is, is that when you borrow short and lend long. So as those short-term rates move higher, all of a sudden, you’re earning less on your assets and you’re paying out on your liabilities. And that is not sustainable. And that’s why that front end of the curve really can indicate some financial stress pretty quickly, generally speaking historically has been a pretty powerful measure.

Scott Krauthamer: As it relates to equities, if we just take a step back, what really matters with equities, it’s really just two things. It’s what are the earnings and then what’s the multiple that people are willing to pay for those earnings. And if you pay attention to the earnings level, the earnings level’s actually okay right now. If things were to change then obviously then that would be a negative signal. We are, you know, basically finished with Q1 earnings season. It was a very strong, you know, earnings season. And while we do think that there’s likely going to be a slowdown, we don’t see that slowdown equaling a complete halt. So, if you think of all the times where earnings growth, like we’re seeing this year, has been above 10%, the market’s never been down. So, we’re quite confident that going forward, as long as the earnings are there, the multiples can come down a little bit. We don’t think that that’s likely to happen, but they don’t need to go up a lot, which I think has been what a lot of the market has been driven on over the past call it 10 years, it’s all been about multiple expansion. We think if the earnings changes that would be a sign that we might need to get a lot more conservative.

Shannon Rosic: Okay. So, bottom line, don’t play favorites when it comes to picking which market is a better indicator. But a question for all of you though, maybe just what’s one challenge each of you face in the active manager space right now, love to start with you.

Frazer Rice: So I guess really, it’s just articulating to those people who have a preconceived notion that active management has problems right now and saying that there are benefits to having portfolios that are constructed with active management, that they can be additive toward the solution, toward getting you towards your goals. Really people I think have read a lot of and whether it’s in one publication or another or otherwise, they have taken a lesson from maybe the hedge fund community and maybe they haven’t performed as well as has been advertised. But that doesn’t mean you should throw the baby out with the bathwater. And so, what we try to do is just understand what’s important, first of all, making sure that they understand what their appetite for risk is, how to allocate a portfolio around that. And then in implementing it, saying that, “There are places where active management can be additive to it. And that’s going to be in furtherance of your goals going forward.” So really sort of unwinding a lot of negative press that’s happened in the last few years. And rearticulating the value proposition, that’s the challenge.

Shannon Rosic: Sure. And, David, what about you?

David Hillmeyer:I think I’ll approach it from a perspective of just risk management and active management. And, you know, one of the biggest focal points right now is just the liquidity in the market. And what is that going to mean for all asset classes, whether we’re talking about fixed income or equities? And that’s the big question right now is as you’re starting to see a shift in the psychology in the market that I think Frazer’s earlier point about interest rates, you know, we’ve all been talking about interest rates moving higher. We really don’t think that that’s the big worry because of the structural headwinds that are in place. But the reality is, if Central Banks are pulling back liquidity, that’s going to come with consequences. And what does that mean for us as risk managers? How do we need to be positioning our clients’ portfolios when the liquidity landscape changes? If we thought asset prices moved higher as a result of Central Banks providing liquidity, and we rode that ride, what does it mean then? It’s not a hugely parfait to assume that if they start to extract that liquidity that you could have a degree of the opposite effect impacting valuations. That’s something that we’re thinking a lot about right now.

Shannon Rosic:Sure.

Scott Krauthamer: And on the equity front, I mean it’s similar to what we heard from Frazer and David. It’s really making sure we can explain to our clients the value proposition. Where can we add value? And where might we not be able to? And I think the challenge for the whole industry is making sure that we can say, “Look, above and beyond what you can get in a passive (a) can be done; and (b) it is worth paying for. I think the other aspect of what’s happening is the amount of, you know, conversations about passive, having this, again, one kind of broad stroke that all passive is created equal. I think the amount of money going into these kind of sector ETFs are creating a lot of distortions. So, we as active managers have to look at that and say, “Is this is an opportunity?” With all of that money chasing these, just big ideas without any sort of knowledge of what’s actually under the hood, we think that that is both a challenge but also an opportunity.

Shannon Rosic:And, David, explain how beating the benchmark and generating income and limiting downside risk can really ultimately just be a daunting task for active managers.

David Hillmeyer: Well, where we find it probably more challenging is in an environment that’s where you’re experiencing lower volatility, where essentially a rising tide is lifting all boats. That’s where it’s harder to do. You can still differentiate yourself though as an active manager in that type of environment. Because the objective is, if you built out the resources to be able to effectively manage client portfolios from an active perspective, that means you’ve got the research and the expertise in-house that you’re looking at opportunities to move down in capital structure to pick up additional income as an example. In today’s environment, you know, the big thing really, it’s coming down to is what are rates going to be doing from this level? And that’s the big daunting task that I think that we’re facing at this point. But just remember, we have a tremendous amount of tools in the toolbox to be able to address changing market environments. And that’s the beauty of active management is that you have a lot of leverage you can pull to change the risk profile fairly quickly, in a passive strategy you don’t, you’re along for the ride. In an active strategy you can actually change course if you need to.

Shannon Rosic: And this might be a bit of a scary thought, but what happens when a manager changes their philosophy?

Frazer Rice: Well, that’s another issue with active management is that it’s not a onetime decision to pick a manager. And much like when you do a will early on and then circumstances change and you’ve got four kids instead of one, you need to rethink things. An important part of active management I think is monitoring your managers. I think you can go into one manager at one point in time and hopefully they’ve got a process and a methodology in place that you can rely on over a market cycle through the ups and downs and so on. Where you really get into trouble, and I’m sort of taking an equity component, just because it’s an easier example, but if you were in a dividend based strategy or a value based strategy and all of a sudden they start moving into tech names or Google or something like that, that that is different from what you were promised way back in time, then you’re dealing with something called style drift. And then the active manager that you thought you were paying for is doing something that’s different. And that may have interesting short-term success but ultimately that to me is scary because then you’re … the methodology under which you were promised is no longer there. And that really is more of a roll of a dice at the casino than it is an intelligent investment decision.

And if you’ve built a whole portfolio based on the integration of one manager with another one, then you start getting into the area where you could have concentrated risks that you didn’t think you were going to be getting before. And that’s where monitoring managers over a period of time and understanding why things performed worse than the benchmark, or even more importantly in some ways, why they outperform the benchmark is just as important. If someone were in a value manager and suddenly they were in Apple for six months and it took off and all of a sudden, they’re outperforming by 10% or something like that, that’s a nice outcome, but it in some ways came for the wrong reasons. And when you get into that framework that’s something to really pay attention to.

Shannon Rosic: Sure. And, David, you know, and not staying on scary topics, but when it comes to politics, you know, you’ve touched on it a little bit before, but what does Washington, you know, what’s their role currently, where do they fit into all of this?

David Hillmeyer:They introduce uncertainty. The reality is, is that you need to be paying attention to what Washington is doing. You need to do your best to understand it. At times it can be very difficult. But I think we touched on the Iran deal as an example. But trade, you know, trade, I think trade talks and concerns around global trade and what that can mean to global growth has gotten markets a little bit spooked. Trump’s policies, he’s been rolling back regulations. What are the impacts on certain sectors as a result of that? And the commodity space for example, around pollution controls or something along those lines. So just understanding and having a view around it. And another interesting thing is that really what does happen in the fall around the elections, do we see the House and the Senate swing one or the other. And what are the potential implications of that? Could that make challenges for the Tax Reform legislation that was passed in late 2017? Thinking about those types of questions and building a thesis around potential outcomes and understanding probabilities to those outcomes helps you make better risk management decisions in the portfolio. But following, it is important to ignore that can be detrimental.

Shannon Rosic: Absolutely. So just final thoughts then gentlemen. And, Scott, I’ll start with you. But how have you seen the industry’s approach evolve towards active management and what are your predictions and hopes, you know, moving forward?

Scott Krauthamer: Predictions and hopes, let’s see, [inaudible]. Well, I think I kind of share kind of three main points on this. I think the real future will not look like the past. If you think about the past 10 years this pure kind of beta play that has worked so well will not likely continue in the future. While that might sound like a negative from an investor standpoint, it’s actually a positive from an asset management standpoint because we see a lot of this volatility and dispersion that I talked about earlier as opportunities for us to add value. I think from an active management standpoint; the industry has to evolve. And I think acknowledging and reflecting and actually making some enhancements to how we engage and the vehicles that we create is critical. And I mentioned an example of that earlier of maybe a way to develop a strategy where you get paid as you create alpha, and if not, you pay ETF like fees. That’s where I think the world also needs to go. And finally, in this different environment, I really do believe that returns might be a little bit lower than we’ve expected over the past few years. And in a lower return environment active management’s role is that much more impactful. If you can add 2% on top of a 6% return that’s a big deal. If it’s 2% on top of a 17/18%, it’s not as meaningful. So, I think that active is going to be in the spotlight and I think for positive reasons.

Shannon Rosic: Great, David.

David Hillmeyer:Well, I think I’ll just leverage off of what Scott was saying, just in terms of just … and I’ll go back to just the idea of client engagement and managing expectations and making sure that your clients understand what the potential outcomes are in the environments that we’re in. And it kind of goes back to managing return expectations. You know, if you look at the bond market as an example, we’ve enjoyed a secular bull market since 1980 essentially. So, we’ve had tremendous momentum and we’re down here, we’re bouncing off the bottom, you know, yields are still extremely low. But the simple bond math makes it very challenging, particularly when you don’t have a significant amount of income coming off the asset class. And you can experience some price volatility. And when you factor those in, managing expectations is important. So, your clients understand how and what you’re going to deliver so that they can plan their own portfolio needs on the other side. So that’s, I think, an important point.

Frazer Rice: I think my hopes and expectations diverge. I hope that active management will continue to be a forceful component, and I think it will. However, I think that the industry’s going to consolidate. I think there’s a lot of room for duplication and average results to be pared down. So, I think that in general I think the fees for active management are going to decrease for the average. And they’re going to sort of creep down toward more of the passive fee element, it’s already started. I think also firms are going to consolidate in order to remain competitive. I think scale is going to continue to be important. I think we are in the on-deck circle as it relates to the impact of artificial intelligence and machine learning. And so, where it may have taken 10 analysts to come up with a new idea, it may take two and a really strong computer to do it. And so, I think the economics of what it means to be an asset manager, we’re just now starting to understand what that is. The good news is, is that I think those people who can outperform the market over time will thrive and grow. And so those people, if you can get in on the ground floor or early in their cycle I think you stand to really benefit from them and those firms and investors that are able to identify those people early, I think there’s a chance to really get in on the ground floor and take advantage of active management going forward.

Scott Krauthamer: I would actually like to just jump in on that point. I think that that’s a really important measure and something to talk a little bit more about is the fact that with this kind of wave towards passive, I do think right now there’s a lot of confusion out there. In fact, there’s more ETFs and indices than there are stocks. So, there’s lots of distortions being created in the marketplace that should provide active managers a better environment. But the consolidation will likely continue, and I think that’s actually going to be even a better environment for the last active manager standing.

Shannon Rosic:I was going to say that was my last question. But actually, you brought up an interesting point about technology, is that a fear for active managers right now that we’re going to see this shift allowing things like AI to take over those [inaudible]?

Frazer Rice: Well, I think absolutely, I think there’s no question that technology is going to have a seismic impact on the active management industry, if you’re a hedge fund manager and you don’t have a satellite up there counting cars in a Wal-Mart parking lot, you’re at an information disadvantage from the other guy who does. Taken to a different extreme, if you don’t have the algorithms in place that keep you on a par with the Fidelities and Schwabs and other ETF providers, Vanguards of the world that are able to deliver passive at an extremely low basis point fee, you’ve got a competitive disadvantage you have to overcome ether through skill or through some other edge that you’re able to generate. Those companies that are able to take advantage of AI machine learning, some of the other tools that are in place, incorporate them into their repeatable process and then use that to generate long term returns, they’re going to thrive. They may even be able to charge more for what they’re able to do. But I think that’s going to be the rare asset manager that’s able to do that. And so that makes it all the more important when you’re trying to identify them, that finding that culture of innovation within that asset manager, that’s what’s going to allow them to survive/compete/grow over the course of the next 5-10 years. And if you’re an investor with a long-term time horizon, that’s what you’re looking for. I mean you don’t want to be with a group that does well for two years and then they crater. You’re looking for a nice long market cycle type of return. And with technology moving as quickly as it is, I’d say that those firms that you can identify they’re able to embrace it and weave it into their process, those are the ones that are going to be interesting.

Shannon Rosic: Great. Well, gentlemen, thank you so much for your insights today, much appreciated. For Asset TV, I’m Shannon Rosic.

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