An active approach to global equities is key

Paul Markham, Investment Director, Global Equities emphasises the importance of active management amid ongoing shifts across industries.

08 August 2024

The continued growth in passive investment strategies raises a critical question: is the only viable approach to keep pace with the market to simply index or invest in an exchange-traded fund (ETF)? This trend poses a challenge for the investment industry, as it may deter potential investors from considering active management. However, this phase is unlikely to persist indefinitely, and I believe a significant opportunity awaits. This opportunity hinges on the industry taking a moment to regroup, moving beyond the relentless pressure from passive strategies and fee competition.

A great believer in active management

I firmly believe in the merits of active management. I think it is important to build concentrated portfolios with a high active share and some diversification of risk as a means of delivering longer-term outperformance for our clients. Clients expect us to back our convictions and are not paying us to hold high levels of cash. And by diversified risks, I think it is important to spread risks across different sector and regions we favour, while also implementing our thematic views. I think successful active investing is about taking the right amount of active risk, especially in today’s skewed markets where there is a concentration in a small number of megacaps.

For some investors, their starting point in global equities might be a low-cost tracker on something like the MSCI World Index, which might do a basic job for them when markets are going up. But, as we all know, markets do not behave the way we want them to, and I believe that active management delivers for investors during the ebbs and flows of markets over the long term. After all, we must not overlook the mathematical realities of investment performance over time. Consider this - from both a volatility and capital accumulation standpoint, it is more advantageous to outperform in a declining market than in a rising one. Consider the simple mathematical fact that a 50% loss requires a 100% gain to recover. This principle underscores the value of active management, especially in a falling market. For instance, if the market drops by 30% and an active strategy only captures half (or 15% of the fund’s value) of that decline, it is a more favourable outcome for long-term capital growth compared to capturing an equivalent 15% gain in a rising market. The mathematics of recovery are more favourable in the former scenario. This is a fundamental truth of investing. I believe that active management can deliver more attractive results for investors over the long term.

Benchmarking and portfolio construction

The starting point for retail investors is typically cash, which is considered a low-risk asset with a stable return, hence its 'low beta'. However, it is important to note that cash sometimes offers lower yields compared to the equity market, and this was the case for a decade after the Global Financial Crisis of 2007-08. Growth equities, particularly in the tech sector, are characterised by their potential for significant revenue or earnings growth, which can lead to higher returns. However, they also come with higher volatility, or 'high beta', compared to cash. Therefore, it is not appropriate to benchmark growth equities against cash due to their differing risk profiles and potential returns.

Like my peers at GAM, I firmly believe in portfolios with focused positions and high active share. This does not mean, however, that all consciousness of the opportunity set, or eligible universe, should be eschewed. In recent years, a key case in point is that of the MSCI World Growth index, which is the reference performance benchmark for the GAM Disruptive Growth strategy. As performance leadership within the global equity market has narrowed after a long period of strong returns from the technology sector (latterly narrowing further into the beneficiaries of Artificial Intelligence), the upper echelons of the index have been dominated by the ‘big beasts’ benefitting from this trend. This is no reason to invest in them in and of itself – and avoiding underperformers within this cadre can be a significant source of relative outperformance. However, it is important to be cognisant of what constitutes a ‘neutral’ position in order to be able to establish clear blue water between this and our holdings. In other words, it is no good being fundamentally positive on a stock if the fund’s holding is smaller than that of the reference benchmark. This aspect of portfolio construction – and right-sizing positions – is important in my view.

Embracing active risk in the market is a fundamentally necessary approach. While I occasionally hold underweight positions in the largest stocks – generally en route to a more constructive position I maintain a zero weighting in many large caps. I am committed to making bold decisions, fully aware of the substantial influence these stocks wield on our relative risk profile.

Large caps versus small caps

I understand the argument that innovation and disruption can sometimes be more difficult for large companies than smaller ones, because by definition the challenger or disruptor usually tends to be smaller. The operational agility often associated with smaller, challenger companies can give them an edge in this regard. However, it is not solely the size of the company that determines its capacity for disruption.

For instance, Nvidia, despite being one of the largest companies globally, continues to be a disruptive force, with the potential to be revolutionary for various industries through its enabling of Artificial Intelligence (AI). While there is a common perception that smaller entities are the primary sources of innovation, this is clearly not always the case. Large companies can, and do, play a significant role in driving change and disrupting markets.

Focusing on the actual activities and contributions of a company to its industry - regardless of its size or market recognition - can provide deeper understanding of its potential for disruption. This perspective allows for a balanced view, acknowledging that both large and small companies can be instrumental in introducing transformative innovation.

Embracing industrial diversification in disruption

Disruption is a phenomenon that transcends traditional boundaries and is not confined just to sectors relating to technology. It can manifest itself in any industry, including financial services, healthcare and beyond. From that point of view, I have a focus on fostering a broad range of industrial diversification.

While technology will likely remain a key enabler for most companies, this does not necessarily need to be the primary focus of all stocks in the portfolio. Companies can be disruptors through secondary applications of technology, provided they have visionary management teams with the capability to execute and resonate with their end client base.

Home appliances

Applying a disruptive investment strategy in the apparently mature and saturated home appliance market might come as a surprise to some. But this area includes unconventional choices like kitchen equipment and barbecues, which, despite their seemingly mundane nature, can indeed be quite disruptive within their target market.

Take SharkNinja, for example, a company that has significantly disrupted the market for vacuum cleaners and air fryers. By identifying consumer needs, innovating products and implementing strategic pricing, SharkNinja has experienced rapid growth and emerged as a leading brand in several countries. The company operates three research and development (R&D) hubs that ensure continuous innovation, responding swiftly to consumer insights. SharkNinja's product line, known for its compactness and versatility, is designed to accommodate smaller kitchens and adapt to changing lifestyles. This approach exemplifies how technology can be harnessed to redefine an industry and pose a challenge to legacy brands.

Financial services

Blockchain technology is set to transform financial services by enabling direct and efficient transactions, bypassing intermediaries for improved speed and transparency. This shift necessitates significant IT investment and structural changes within the banking system. Networks like Visa and MasterCard are likely to evolve to support this new infrastructure, aiding the move towards a cashless society and the proliferation of contactless payments. The growth in online and contactless transactions benefits these networks, leading to further investment and network improvements. However, this transition may challenge governments in cash-reliant regions, potentially affecting the informal economy and exposing governmental corruption. Despite these challenges, progress towards digital transactions is expected to continue.

Healthcare

Healthcare is on the brink of a new growth era, driven by breakthroughs in diabetes and weight loss treatments from leaders like Novo Nordisk and Eli Lilly. These companies are at the forefront with their GLP-1 agonists – injectable drugs that simulate a hormone that lowers blood sugar and promotes weight loss - revolutionising weight management and reducing obesity-related health costs. Research and development is pivoting towards user-friendly oral medications, with the potential to overhaul healthcare management by promoting personal health efforts before medical intervention.

GLP-1 therapies are not just promising for weight loss but also offer broader health benefits, improving diabetes management, liver and kidney functions, reducing heart disease risk and potentially lowering cancer incidence. The economic implications for governments and insurers are significant, given the current burden of lifestyle diseases.

Smartwatches

Smartwatches and the sensors within smartphones have revolutionised personal health monitoring and data collection. These devices enable a range of applications, from fitness tracking to medical research. The vast amounts of data collected can be analysed to create solutions with a high probability of success. However, the responsibility now lies with healthcare providers to utilise this data effectively. The recent advancements in managing lifestyle diseases are a testament to the potential of leveraging big data in healthcare.

Semiconductors

Semiconductors stand at the intersection of significant tailwinds and headwinds, embodying the dichotomy of the sector. On one hand, consumer-related semiconductors are cyclical, powering devices like smartphones and personal computers (PCs). On the other, AI-related server semiconductors, represented by companies like NVIDIA, and their second derivatives, such as TSMC and Micron, chart a different course. Valuations within the semiconductor sector have diverged sharply between these two tracks, further complicated by geopolitical tensions, notably between China and Taiwan, and policies like Donald Trump’s ‘America First' stance, which introduce volatility.

Despite this, the competitive position of the sector remains attractive. The political rhetoric surrounding Taiwan and the persistent threats from China present risks that are gaining renewed attention due to recent comments from Trump. However, optimism for the semiconductor sector and AI remains high. The long-term transformation in technology utilisation and its influence on businesses and individuals is significant. This ongoing evolution suggests that Configure-To-Order (CTO) will play a pivotal role in navigating these changes.

Thematic and diversified approaches

Combining the thematic and diversified approaches to investment, we recognise the importance of a strategic outlook that navigates the complex interplay of global political, social and economic shifts. By identifying and leveraging thematic tailwinds such as AI, and avoiding potential headwinds, we aim to prioritise businesses with discerning management teams. For example, companies like NVIDIA and TSMC exemplify the competitive advantage crucial to succeed.

Simultaneously, we advocate for a diversified approach to mitigate risks and ensure long-term sustainability, especially in volatile markets. The global approach to equities, with its exposure to a variety of industrial sectors and currencies, becomes increasingly relevant in the current political climate marked by deglobalisation trends. I believe this dynamic asset allocation is not only desirable but advantageous, allowing for a more stable and adaptable investment strategy that can deliver attractive returns for our clients over the long term.