Why Active Management Makes Sense When Investing Internationally

Over the last two decades "passive" investing through index-based mutual funds and exchange-traded funds has become a staple of the investment industry. But when you think about it, indexing really isn't that passive. And when it comes to performance, it falls short more often than many people think.

Market cap weighted indexing, the oldest and most common variety, is essentially a momentum-driven strategy. When stocks and sectors become increasingly popular they occupy more and more space in the index's weighting and account for a larger share of its performance. Expensive stocks rise to the top of the index scorecard while more reasonably priced ones, even those of good companies with strong balance sheets, occupy less space.

Indexing tends to work best in a strong bull market, when a rising tide lifts all boats. But when markets are choppier and investors become more selective, the positives of active management tend to shine through.

The performance of U.S. mutual funds underscores the cyclical nature of the active versus passive debate. One study found that in the five years ending 2017, a mostly bullish period, index funds that followed the Standard & Poor's 500 Index outperformed actively-managed funds in Morningstar's large cap blend category for four out of five years. But in the choppier period from 2000 through 2009, the actively managed group outperformed the index funds in nine out of ten years.

Navigating a shifting landscape

Of course, no one can say with any certainly which direction markets will take in the future, or whether active management will outperform passive going forward. But there are growing signs to indicate that the long bull market that's prevailed for nearly a decade could give way to more wavering times that magnify the importance of an active stock selection that adjusts to shifting economic and market conditions.

One concern is valuation. U.S. equity market valuations are at their most expensive levels in over a decade, and others are catching up. With increases in interest rates, the economic growth that has buoyed markets could slow down. And it is likely that the full brunt of protectionist trade policies have yet to be felt.

For investors who want to cover the widest possible range of economic scenarios, including actively managed funds in the investment mix is a logical strategy. Active management can be especially effective in global and international investing, where managers have the freedom to roam a broader investment universe for high quality companies with growth potential and reasonable valuations.

"As active managers we have the ability to select companies from around the world with favorable characteristics such as attractive market share, high barriers to entry, strong cash flows, and low levels of debt. Those attributes have proven to be valuable to investors, especially in uncertain market environments," says Martin Connaghan, investment director at Aberdeen's global equities desk in Edinburgh, Scotland. "Indexing doesn't take into account quality or valuation, and it doesn't weed out the bad apples."

With hundreds or even thousands of stocks, it's very likely that an index holds at least one time bomb that could drop precipitously on negative headline news. When signs of deep problems at a company first start to appear, and well before the press gets wind of them, active managers have the ability to exit a stock quickly and avoid potentially devastating blow-ups. Passive indexes can't make such judgment calls or take such action.

An important part of the investment process at Aberdeen is an environmental, social, and governance (ESG) assessment that can reveal critical information about a company's values and practices, as well as potential risks for investors. A growing body of evidence suggests that when companies are careful to maintain ESG standards, they are less likely to generate the kind of negative publicity that hurts shareholders.

Perhaps most importantly, active management at Aberdeen is a forward-thinking process that takes into account not only on what's going on now, but what may happen to a company's business in the future under a variety of economic conditions. Over the long-term, this attention to possible future economic scenarios and attention to downside protection has the potential to help investors realize better returns than they could with indexing alone.

The international advantage

Global active managers also have the ability to determine which countries or regions to emphasize in portfolios based on factors such as market valuation and economic growth potential. In the U.S., the explosion of domestic exchange-traded funds has elevated demand for the stocks that appear in their correspondent indices and given a relatively narrow band of stocks a big say in performance. The top 50 stocks in the S&P 500 Index, for example, make up 40 percent of that benchmark.

"A lot of stocks in the popular U.S. indexes are overvalued," says Connaghan. "They are definitely a crowded trade." Many of them, he adds, have been well trodden by investors and are followed by a swarm of equity analysts.

By contrast, valuations in other areas of the world aren't as expensive. Many of these companies also tend to receive less coverage from analysts, even though they have spotless balance sheets and similar clout and recognition at a global level. The lower profiles of many international stocks, along with their more reasonable valuations, opens the door to finding "hidden gems" that fly under the radar screens of most investors.

Managing globally also provides a broader palette of value enhancing strategies for managers. Just as each country has its unique culture and customs, the investment and economic climate among countries runs the gamut. Aberdeen's global equity managers can tailor strategies based on factors such as how the political landscape might affect certain industries or countries, which markets have the most attractive valuations and growth prospects, and which companies have the financial stamina to prosper during both bullish and bearish economic times.

Often, making judicious investment decisions means going against the crowd. "While we take into consideration what sell-side analysts have to say we are not satisfied by a majority opinion and we aren't wedded to their recommendations," says Connaghan. "Instead, we focus on the potential for change at companies and where we think the consensus is wrong."

To help ferret out the real story, every company in Aberdeen's equity portfolios has received at least one personal visit from a company analyst or investment manager. "Visiting a company and meeting with as many people as possible allows us to get the whole story, and to assess things that may not be well-understood in the investment community," says Connaghan. "That's particularly true as you go lower on the market cap scale or into more unusual geographies."

Why Aberdeen?

Headquartered in Aberdeen, Scotland, and with 46 offices in 24 countries, Aberdeen Standard Investments is uniquely positioned to capitalize on the world's most promising global opportunities, regardless of where they originate. With $735.5 billion under management, as of June 30, 2018, across diverse asset classes, the firm delivers original thinking, proprietary research, the highest level of service and support to thousands of institutional and retail clients.

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