Since the Great Recession investors has seen a prevalence of low interest rates. Interest rates tend to fall when the economy is not doing well and rise when conditions are on the upswing. Lower rates and expectations for the economy limits the number of stocks that investors can pick from
"Equity fund managers have felt the pain over the past 40 years whenever interest rates fell", says Joseph Mezrich, the head of equities quantitative strategies at Nomura. But there are new ways in which low interest rates are hurting active funds' performance — and this pain could continue to if managers do not course-correct, Mezrich said.
A post Great Recession trend that has not been followed is the collection of high interest yield stocks. The low interest rates have fueled the rise of stocks that offer the kinds of yields investors earned when rates were structurally higher. Since 2011, these so-called bond proxies that are part of the Russell 1000 have consistently offered dividend payouts that exceed the 10-year yield, Mezrich said.
"The problem is that despite this built-in advantage, active fund managers have tended to underweight high-dividend-yield stocks and overweight low-dividend-yield stocks, positioning their portfolios in a manner that does not benefit them", Mezrich said.
Active fund managers will likely continue facing headwinds "if America goes the way of Japan, with interest rates drifting towards zero, and if current cost-cutting trends in the financial services industry continue," Mezrich said. The good news is that there are ways to avoid what Mezrich says is coming.
- Moving forward in a lower-interest-rate world, one way to remedy fund underperformance is to flip the script and gain more portfolio exposure to the high-dividend-yielding stocks they were previously underweight.
- Managers must be aware of how low portfolio turnover can hurt their performance.
Mezrich also warns that managers should avoid what he calls the "momentum trap." When a fund's performance becomes driven by a few outperforming stocks, it inevitably becomes exposed to the downside scenario.
"Increasing portfolio turnover may be the simplest corrective for this 'momentum trap,'" Mezrich said. "More generally, control of unintended momentum tilts by optimization or momentum factor hedging would help."