Get active

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By Guest Blogger Scott Booth

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As we close out the 2024 calendar year, uncertainty about the future abounds. Political implosion at the federal level in Canada means an election is coming, tariff threats are ominous and on the horizon in the new year, and ruling parties are falling from power across the developed world with change in the air…there is kind of a lot going on right now.

Bond and stock markets swooned on Wednesday as we got another widely anticipated interest-rate cut from U.S. Federal Reserve Board (the Fed). The problem? The dots told markets to expect fewer rate cuts in 2025. We’re down to two 25-point reductions anticipated in the U.S. over the next 12 months.

It seems that the Fed is now incorporating Trump’s incoming policies into their world view. When one considers some of the key pillars that are to provide the foundation for making America great again 2.0; Trade, fiscal and immigration policies all seem to point to renewed inflationary pressures. On the positive side of the ledger there was also an uptick in growth expectations.

The latest GDP numbers out of the U.S. seemed to reinforce this, as they showed the U.S. economy grew at a 3.1% annualized rate in Q3/24. Not bad at all.

Rate cuts from the Fed started in mid-September of this year, and with the latest drop they have now shaved one percent off the overnight rate. Historically, declining overnight rates have corresponded with longer term bond yields coming down as well.

Not this time.

When the Fed first cut the overnight rate in September the 10-year U.S. Treasury rates were a little over 3.7%. They now sit a little under 4.6% as growth and inflation expectations shift higher.

It certainly seems that in that bonds are likely to struggle a bit in the near future with spending high, interest carrying costs ticking up and more deficits and inflation on deck. A significant drop in government bond yields in the seems unlikely in the absence of a broader economic slowdown. Expect longer term-yields drift up or sideways for a bit.

Corporate bonds, both high-yield and investment-grade have had a really good year as credit spreads have tightened in significantly. Riskier fixed income assets have generally been the best performers. The health of corporate America is, and has been, on the mend…while government and treasury balance sheets are going the other way as fiscal restraint has not been the reality. No need to sell this stuff as the economy remains strong…but the easy money has been made for credit investors.

Many readers buy into the well-conceived notion of building balanced, diversified, global portfolios out of ETFs. They are on the right path. No major changes required. There is no shortage of options for these portfolio building blocks.

For the growth stuff in portfolios (stocks), it often makes sense to take a passive approach and index, as the historic track-record shows that passive, index-tracking vehicles have generally outperformed active managers. This isn’t to say there aren’t great active managers out there, we own some active solutions in client portfolios…but the majority aren’t worth paying for.

Looking back over the last decade there has been a clear shift toward passive equity investments reflecting this reality. Nearly half of all U.S. stock fund assets are invested in mutual funds and exchange-traded funds that passively track indexes. Jack Bogle would be thrilled.

US Equity: Cumulative Net Flows 2014-2024

Source: Guggenheim Investments, Morningstar as of 6.30.2024. 

For the “safe” stuff in a B&D portfolio, the fixed-income allocation, the flow of funds looks starkly different, with active solutions attracting significantly more investor dollars than passive ones. The chart below illustrates institutional flows into fixed income investments over the last two decades. Passive investments are increasing, but not at the expense of active solutions, which are attracting more of the funds being allocated to fixed income solutions.

Fixed Income: Cumulative Institutional Flows 2005-2024

Source: Guggenheim Investments, Morningstar as of 6.30.2024. 

The reason is that active fixed income managers do tend to beat passive investment alternatives. A recent study by Morgan Stanley looked at the last decade, dividing it up into 84 rolling 3-year periods ended 12/31/23. The study tracked the percentage of these periods where active outperformed passive for a variety of market segments. The results are tallied below.

Source MSIM Research, Morningstar as of December 31,2023

The study noted that active outperformance has been a consistent theme through time, across a number of market segments, not one just buoyed by recent outperformance.

The authors further opined that that the structure of passive funds in fixed income investing robs them of the flexibility to adapt in changing markets. Active solutions can manage factors like credit quality, duration and be selective with exposures to different market segments while avoiding securities / problems altogether. Passive solutions are often more limited in their investment options and may be obligated to buy/hold/sell some securities that may be less than ideal in any given circumstance.

Passive, low-cost solutions can be great and are often advantageous for investing in highly transparent, liquid markets.

As asset-class heterogeneity and complexity increases and when price discovery gets less transparent, it creates opportunities which astute managers can exploit. In these instances, active solutions can be more effective than passive ones for exposures to assets like bonds and preferred shares.

Scott Booth, CFA, is a seasoned financial advisor and licensed portfolio manager. Over the past 18 years he has worked in the capital markets as an analyst, trader and advisor with major banks and now with Turner Investments.

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About the picture: “Charlie, our 4 year old Cocker Spaniel, came across this jolly old lad at a Calgary dog park this week,” writes Rodney (pictured above). “I wished for world peace; Charlie wished for treats & stuffies. All the best in 2025. My New Year’s resolution is the same every year: I resolve to have a boring year. Never works out……..”

To be in touch or send a picture of your beast, email to ‘[email protected]’.

Source: https://www.greaterfool.ca/2024/12/20/get-active/