May 4, 2010

Active Management: Is it Time?

More than ever, financial advisors are pondering where to allocate client capital in today's market environment. The reason? It is difficult to make a distinct case that any one asset class is positioned to break out with above average returns over the next market cycle. Equities are largely believed to be overpriced with expected returns unimpressive after accounting for low current yields, inflationary pressures, and questionable prospects for long-term corporate profit growth. Meanwhile, investment grade fixed income is hovering just above ground with near-zero real return yields, and high yield bonds have literally closed the spread gap after last year's rally. With the easy money off the table, we seem to be entering an environment of flat single-digit returns in nearly all asset classes.

There are still small opportunities between market segments on a relative basis; however, it is when market returns are muted that specific manager tactics can have a more meaningful impact on performance results. As such, advisors should consider increasing the degree of active management within the market segments or consider non-traditional, alpha-oriented strategies. In areas where the "beta play" seems to be over, and for investors that use benchmark hugging managers, it will be difficult to combat the full brunt of these market headwinds.

Metaphorically, this change in portfolio construction strategy is analogous to trading in one's paint roller for a cutting brush. Specifically, it is finding managers that dig into security and deal-level alpha and finding those that are navigating the still-inefficient pockets of picked over markets.

There is a distinct art to implementing capital market assumptions, specifically around understanding where direct beta exposure is desired and where a manager's hands should be unconstrained. In 2010, a desirable implementation strategy may include managers who are security-pickers, who have more latitude across a company's capital structure, and who seek absolute return. In this environment considerations should be given to long tenured teams with a history of adding value through security selection in potentially illiquid and opaque markets, and the latitude to do so.

To the original question--where does one allocate capital in today's markets? Avoiding broad based market exposure while exploiting the less-obvious pockets of inefficiency may be the answer. Mutual funds such as Eaton Vance Global Macro Absolute Return I (EIGMX) and Third Avenue Focused Credit Instl (TFCIX) are positioned as such: they take security level bets arrived through strong resources and research, while circumventing unwanted beta and broad market factors. Eaton Vance Global Macro seeks to mitigate exposure to four global market factors: the U.S. credit markets, U.S. interest rates, global equities, and the U.S. dollar/Euro exchange rate. Using primarily fixed income, Eaton Vance opportunistically takes security-level long/short positions that seek to mute the market movement within the portfolio, while allowing security-level bets to play out. Third Avenue, founded by distressed credit guru Marty Whitman, has launched Focused Credit, a distressed debt fund that can run the gamut of the corporate capital structure. Third Avenue not only invests in high yield and bank loan securities, but also enters capital infusion transactions such as debtor in possession (DIP), financing and exit financing, as well as debt-for-equity transactions. While many managers easily capitalized on the general mispricing of the high yield and bank loan markets of 2009, not everyone has the skill set and the history of attracting and navigating distressed debt deals that Third Avenue boasts.

In short, there are opportunities in a flat market environment; however, the implementation tactics have changed. The time may be ripe to seek more alpha oriented active managers in favor of closet index "beta plays." At the same time, help your clients understand a manager's alpha thesis and their competitive edge in executing on this thesis. Shifting the emphasis of manager selection and portfolio construction toward opportunistic managers may help offset part of the market headwinds investors are likely to face on their way to achieving their financial goals.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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