November 2023 / INVESTMENT INSIGHTS
Can an Active All‑Cap Approach Consistently Add Value Over Time?
And without a significant increase in risk?
- A criticism sometimes levelled at active management is that many strategies struggle to consistently deliver alpha across changing market conditions.
- We consider whether active stock picking, with the flexibility to invest across the full market cap spectrum, can consistently add value over time.
- Importantly, is it possible to deliver on this ambition of consistent added value without also taking on significant additional risk?
One of the truisms of investing is that financial markets are constantly changing, continuously impacted by new information and rapidly evolving dynamics. Indeed, one of the criticisms sometimes levelled at active management is that many strategies struggle to consistently deliver alpha across various market environments. With this in mind, we consider what it means to be a high‑conviction active manager and whether fundamental stock selection across the market capitalization spectrum can consistently deliver alpha generation across varying market and economic conditions.
All‑Cap Remit Provides an Expansive Opportunity Set
Following a bull market run that lasted more than a decade, the US equity market landscape has been much more volatile and uncertain over the past two years. This is where an actively managed all‑cap strategy can be beneficial, providing an expansive opportunity set in which to find quality, well‑managed businesses capable of generating alpha.
Successful navigation of different market environments is exactly what an all‑cap strategy is designed to do, providing the flexibility to invest in companies of any size beyond the well‑known and heavily invested large companies, and across the style spectrum, from high‑growth to deep‑value names. The ability to quickly adapt to new economic cycles and changing market dynamics is central to potentially delivering more consistent performance outcomes over time for investors.
Delivering Alpha Through Various Market Conditions
The T. Rowe Price US All‑Cap Opportunities Equity Strategy aims to deliver on this ambition by generating alpha through various market conditions. The portfolio manager fully utilizes this all‑cap flexibility by applying a unique stock‑picking framework that centres on four key “pillars”: business quality, earnings expectations relative to the market, whether company fundamentals are improving or declining, and valuation. Each of these pillars is multifaceted, and rarely do all point in the same direction; rather, they are intended as a flexible framework to ensure that a wide variety of ideas are considered.
The framework is key in filtering the potential universe, and, importantly, it also helps to focus selection decisions on the fundamental truth that stock prices are ultimately a function of supply and demand over the short to medium term. When there are more incremental reasons for investors to want to buy a stock (i.e., it is in higher demand) and fewer incremental reasons to sell (i.e., supply it back to the market), then prices must find a higher equilibrium point.
Consistent good performance outcomes that the strategy strives for ultimately stem from the fact that the supply and demand framework can be applied in any market environment and helps to avoid becoming overexposed to either growth or value styles or any specific sectors. By keeping style/sector bets to a minimum to avoid potential blowups, we help ensure that active stock selection utilizing the full market cap spectrum remains the principal driver of performance over time.
If we look at the one year performance attribution for the representative portfolio in the US All‑Cap Opportunities Equity Strategy, (Fig. 1), the data indicates that:
(1) positive stock selection accounted for almost 100% of the portfolio’s benchmark outperformance;
(2) the portfolio was broadly exposed to 10 of 11 market sectors (zero or near zero exposure to utilities), with no significant active exposure in any one sector; and
(3) the portfolio exhibited positive stock selection in six out of 10 of those sectors and was broadly achieved across growth‑oriented sectors (information technology), cyclical sectors (industrials and business services, financials, and energy), and defensive sectors (health care). The story is largely the same over longer time periods.
Stock Selection Drove Portfolio Outcomes
(Fig. 1) T. Rowe Price US All‑Cap Opportunities Equity Representative Portfolio vs. Russell 3000 Index attribution analysis
Outperformance Need Not Mean an Increase in Risk
(Fig. 2) Risk vs. Return Analysis: T. Rowe Price US All‑Cap Opportunities Equity Composite vs. Linked Benchmark
What makes this story more compelling still is the fact that the strategy has delivered healthy outperformance without taking on excessive risk relative to the benchmark. A common method of determining portfolio risk, for example, is standard deviation, which measures the volatility or spread of asset prices when compared with the index. It is reasonable to expect that, in order to outperform the index, it is necessary to add risk, resulting in higher standard deviation. However, as Fig. 2 shows, this needn’t be the case. Over the five‑year period ending September 30, 2023, the US All‑Cap Opportunities Equity Composite delivered 215 basis points of average annual outperformance, and with only marginally more risk, (0.01% standard deviation) compared with the linked benchmark.
The successful navigation of variable market environments in recent times is particularly encouraging, given that this is exactly what an all‑cap opportunities strategy aims to achieve: to provide dynamic exposure in order to generate alpha for investors, whatever the prevailing market environment.
Alpha Generation Without Excessive Risk
Risks to the near‑term US market and economic outlook remain prominent, so we are comfortable maintaining a more cautious stance, particularly as the current risk/reward profile of the US equity market provides little incentive to add risk at this point. We believe strong stock selection will be key to generating outperformance in the near term as company valuation and fundamental strengths come sharply back into focus. This backdrop plays to the strengths of active stock picking. Moreover, the large US equity market means that investors with an all‑cap remit can potentially benefit from tapping a broad range of opportunities throughout the market capitalization spectrum and across investment styles, sectors, and industries. Ultimately, consistent alpha generation without taking on excessive short‑term relative risk is possible. However, we believe it requires high‑conviction stock picking, with the flexibility to invest across the market spectrum, and a fundamental understanding of intrinsic company value.
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