In this Monthly Market Advisor:

• As late-cycle market characteristics give rise to new investor challenges, we believe having the support of a well-established manager due-diligence process can help.
• While overlooked by many investors, manager due diligence should be considered a core part of the investment selection process and can help to enhance both upside potential with downside protection.
• In this era of accountability, there is value in having the resources of a dedicated manager due-diligence team, which can provide greater transparency and insights into the inner workings of a fund manager.

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Investing late in a market cycle

Based on the S&P 500 Index, we are currently experiencing the longest U.S. equity bull market on record. For much of this cycle, equity investors were able to achieve strong returns investing alongside the market. As such, passive investing through lower-cost vehicles like exchange-traded funds (ETFs) became quite popular at the expense of their actively managed counterparts. However, during the later stages of a market cycle, investors tend to encounter new challenges like rising volatility and a mounting population of richly priced assets. Such a market environment can reward active asset managers, who can attempt to take advantage of rising volatility and growing dispersion of returns between over performers and underperformers in the market. This can be seen in Figure 1. Research at Wells Fargo Investment Institute revealed that about half of all mutual funds in Morningstar Inc.’s database outperformed their benchmarks in 2017, making it the best year for active management since 2012.

An introduction to manager due diligence

While the trends of previous market cycles and this recent result might entice investors to shift their allocations to active managers, they should take a step back and consider what characteristics define a strong active manager. There are thousands of active managers for investors to choose from, and this selection stretches across numerous asset classes and geographies. Of course, even a novice investor can use screening tools to identify prospective managers. These tools might be available on their brokerage websites or even through the resources their personal money managers provide.

Figure 1: Market Returns Late in a Bull Market

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^{Sources: Morningstar Direct and Wells Fargo Investment Institute, March 31, 2018.}

^{Monthly data from August 31, 1926, to September 30, 2007. All returns are for one-year intervals—the first, second, and third year before a recession—as defined by the National Bureau of Economic Research. Performance results are for illustrative purposes only and do not represent the performance of any investment, nor should they be interpreted as a forecast or as an indication of how the asset classes may perform in any future recession period. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Index returns represent general market results; assume the reinvestment of dividends and other distributions; and do not reflect deduction for any fees, expenses, or taxes applicable to an actual investment.}

^{Intermediate-term government bonds are represented by the Ibbotson Associates Stocks, Bonds, Bills and Inflation Series (IA SBBI), U.S. Intermediate-Term Government Bonds TR Index. Large-cap equities are represented by the Ibbotson Associates Stocks, Bonds, Bills and Inflation Series (IA SBBI) U.S. Large Stock TR Index. Small-cap equities are represented by the Ibbotson Associates Stocks, Bonds, Bills and Inflation Series (IA SBBI) U.S. Small Stock TR Index. Please see the end of this report for index definitions.}

^{Different investments offer different levels of potential return and market risk. Investing in stocks involves risk, and their returns and risk levels can vary depending on prevailing market and economic conditions. Small-cap stocks are generally more volatile, are subject to greater risks, and are less liquid than large-company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. Government bonds are guaranteed as to payment of principal and interest if held to maturity and are subject to interest rate.}

Typically, screening tools focus on sorting through user-selected criteria such as asset class, years managed, assets under management, “star” ratings, and performance. The more sophisticated the tool is, the more robust the screening criteria should be. However, even the most sophisticated screens might provide only general and backward-looking insights. They cannot alert investors in real time when a key investment professional is no longer with the portfolio team. They cannot understand how the manager historically responded to certain market developments, like a market crash. They might be able to summarize the manager’s investment philosophy and process but not the ability to recognize if those foundational principles change. Finally, investor-selected criteria can be prone to change if there is no established due-diligence process in place.

Proper manager due diligence requires dedication, skill, resources, and access. For the everyday investor, this can prove to be a daunting task and might be dismissed as a result. However, when considering the aforementioned late-cycle characteristics, having the proper manager due diligence could provide investors with the appropriate standard of care regarding their investment selections.

A review of passive and active investing

With passive investing, securities are typically selected and traded systematically. In other words, there is very little human intervention and no discretion is used in managing the fund. Consequently, the underlying management costs tend to be lower and, thus, are able to support a lower fee. Furthermore, because there is no “active” security selection, the fund may be viewed as a reliable proxy for the respective market index against which it is being managed. ETFs’ liquidity, variety, lower costs, and easy-to-understand construct helped fuel outsized investment flows into this investment vehicle.

There appears to be a widespread view that passive outperforms active. However, history would reveal that this is not entirely true. It depends on what asset class and market are being observed. As seen in Figure 2 on the next page, over a 29-year period, many asset classes across different markets outperformed their respective benchmark indices. Another key consideration is where we are in a cycle. As mentioned earlier, the later stages of a market cycle have historically been favorable for active management.

Figure 2: Active vs. Passive Historical Record

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^{Sources: Wells Fargo Investment Institute and Morningstar Direct, as of December 31, 2016. The study included the analysis of all share classes of equity open-end mutual funds and exchange-traded funds, excluding money market funds, funds of funds, and obsolete funds. Data were extracted from Morningstar Direct using its search criteria to categorize the funds according to their respective asset class and subcategorize the funds as either active or passive strategies. The period of study is from January 31, 1987, to December 31, 2016, using monthly total returns. Morningstar’s calculation of total returns account for management, administrative, and 12b-1 fees and other costs taken out of fund assets. Success rate is defined as the percentage of active strategies outperforming the passive strategy. Information is for illustrative purposes only and does not predict or depict the performance of any investment or the likelihood of achieving any return on an investment. The asset classes shown may not perform in a similar manner in the future. Past performance is no guarantee of future results.}

^{Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stocks are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Mid- and small-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. Foreign investing entails special risks such as currency, political, economic, and market risks. These risks are heightened in emerging markets. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying property, credit risk, interest rate fluctuations and the impact of varied economic conditions.}

The power of manager due diligence

Many investors are not aware of manager due-diligence resources, despite its important role. One reason for the lack of awareness could be the aforementioned growth of passive investment strategies. Despite the historical and continued success of various active strategies, asset managers are collectively moving to adopt, or at least integrate, more systematic approaches. As a result, many asset allocators may have begun to view the universe of asset managers as being collectively more systematic and, thus, having less variability, lending to more confidence behind their expectations on what those asset managers will deliver. This development has been years in the making and is likely driving asset allocators to investing fewer resources to manager due-diligence efforts.

With this ongoing industry trend, the quality of the work produced by asset managers might become compromised. Also, additional industry developments, such as a rise in regulatory evaluation, might also raise greater uncertainty behind how managers operate. Take for instance the Markets in Financial Instruments Directive II (MiFID II), whose objective is to bring more transparency to the trading of financial instruments and strengthen investor protection. While this is a foreign regulation with oversight from the European Securities and Markets Authority (ESMA), U.S.-based investors should recognized that investment firms are global in nature and those U.S. firms that operate in certain capacities in Europe are bound to abide by much of MiFID II. Furthermore, Steven Maijoor, chairman of ESMA, was quoted as saying, “I would not be surprised if it becomes a model used outside the EU.”

So what does this all mean? While this and other regulations might be well intentioned, there will be inevitable trade-offs, including fund quality, due to the likely outcome of the asset managers bearing a greater cost burden. As such, many asset managers are scaling back critical resources, like external research. In fact, in a September 2017 survey conducted by the CFA Institute, 78% of asset management respondents expected to source relatively less external research¹ (Figure 3).

Figure 3: Impact on Research Providers

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^{Source: 2017 Survey, based on 364 responses. Copyright 2017, CFA Institute. Reproduced and republished from MiFID II: A New Paradigm for Investment Research with permission from CFA Institute. All rights reserved.}

Without adequate research, asset managers might not be able to deliver with the same level of quality or portfolio characteristics as they have in the past. Also, perhaps such developments might cause asset managers to learn how to operate and manage their funds by leveraging newer tools and technology, which could, in fact, lead to a better outcome. These are key reasons for having a skilled manager due-diligence resource behind your wealth management platform. Without the proper due diligence at this stage of the market cycle and against the backdrop of these major industry shifts, the funds that are being selected for an investor’s portfolio might not deliver against the quality and characteristics that were once expected. Manager due diligence may provide investors with another element of potential risk management and return enhancement.

Conclusion

In our opinion, investing late in a market cycle warrants revisiting investment portfolios to ensure they are managed in alignment to one’s objectives, constraints, and values. As mentioned, late-cycle market characteristics could also present many opportunities for investors who hold quality actively managed funds. With the ongoing industry developments, that might lead certain managers to deviate from their traditional philosophies and processes, we believe mitigating the potential risk of a fund’s quality degradation becomes paramount.

By leveraging a well-established manager due-diligence platform like Wells Fargo Investment Institute’s Global Manager Research, investors can potentially have manager quality issues uncovered before they occur. Again, as we progress later into this market cycle, active managers should increasingly be positioned to help investors achieve better performance, making quality manager due diligence even more valuable to investors. Change in our industry will always be present, but investors may be best served by maintaining focus on their respective goals and objectives and seeking professional advice to help maintain alignment to them.

Authors: Wells Fargo Private Bank Regional Chief Investment Officers: Kei Sasaki, CFA, Northeast; Cameron Hinds, CFA, Great Lakes; Sean McCarthy, CFA, Southwest; Marc Doss, CFA, California, Nevada; Michael Serio, CFA, Mt. Northwest; David Roda, CFA, Southeast; William Keller, CFA, Mid Atlantic

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¹ MIFID II: A New Paradigm for Investment Research—Investor Perspectives on Research Costs and Procurement, CFA Institute, Rhodri Preece, 2017