Active fund managers are set to flourish over the next decade as ageing Western populations create a drag on stock market returns and increase volatility.
That’s the conclusion of UBS quantitative analysts that presented their research findings at a gathering of analysts and academics in Sydney on Thursday.
The broker’s Asia Pacific head of quantitative analysis, Paul Winter, told the audience that given current stock market valuations, history suggested investors should expect returns of 3.1 per cent a year over the next 10 years.
“Our expectation for pure beta [the market index return] is well below par and in the world where beta won’t deliver your required return from equities, you really have no choice but to go active,” he said.
Three long-term measures of the broader stock market’s valuation – the Shiller price-to-earnings ratio, the Tobin’s Q ratio and Warren Buffett’s favourite measure, stock market capitalisation to national income – had a consistent message.
“They are telling you the market is sitting at elevated values,” Mr Winter said.
That historically meant a sustained period of low stock market returns and increased volatility.
Mr Winter said that above-average market returns in the 30 years heading into the global financial crisis – from 1980 to 2007 – were largely a function of demographics as baby boomers fuelled a period of economic prosperity, but also abundant capital that resulted in lower interest rates.
“The combination of demographics and falling interest rates drove those phenomenal returns and that has conditioned investor expectations about what to expect in the future,” he said.
But the outlook for stock market returns will look different when baby boomers retire and he’s forecasting a period of higher volatility as a result.
“They will take with them their labour, capital and productivity and leave us in a world with lower growth, and lower interest rates which can’t provide any further benefit [because there is no room for interest rates to fall],” he said.
Mr Winter also pointed out that there was a strong relationship between short-term interest rates as measured by the Federal Funds Rate and the VIX, a market measure of volatility.
But there was a two-year lagged effect – which meant volatility only picked up two years after short-term rates increased.
This, he said, was a function of the increasing cost of capital for firms of varying degrees of quality coming into effect.
“Large high-quality companies may be able to finance for 30 years but smaller, lower quality ones can only finance on a one-year horizon. The median is actually four years.”
“Given half the companies would have refinanced before today and half after the change in the cost of the capital, it [higher rates] will only have impacted half the market. So the average is two years.”
Mr Winter said that he is expecting market volatility to increase now that two years have passed since the US Federal Reserve began raising interest rates, although a corporate tax cut might delay the impact until next year.
The research Mr Winter presented also examined how the stock market had evolved from the 1950s “where long-only mutual fund investors kept the market efficient” to the present where various new players such as hedge funds and high-frequency traders account for a substantial share of trading.
UBS research said that high-frequency traders account for 42 per cent of daily trading volume while quantitative funds and hedge funds account for 16 per cent each and fundamental investors account for 26 per cent.
But Mr Winter said that because high-frequency traders bought and sold on the same day “they had almost no impact on the price of an asset”.
“On a three-year view, 98 per cent of assets are priced based on the views of fundamental investors. The quants are there, but they are really ironing out those behavioural mispricings.”