Change of regime, the return in force of active management?

The consequences of the ECB's quantitative easing 

The last decade (2012-2022) started with the euro crisis and ends with the European energy crisis. In the meantime, two major phenomena have shaped the financial markets: falling interest rates and rising equity markets. Both are linked to the ECB's historic decision to orchestrate Quantitative Easing (QE) on a scale never before seen.

The size of the ECB's balance sheet has quadrupled as a % of GDP to reach 61% in 2020. The 10-year OAT has gone from 2.8% to 0% in 2020. Short-term rates have become negative. All these elements show that this QE has disrupted the classical formation of financial asset prices.

The emergence of passive management

With interest rates close to 0% or even negative, equities have become a particularly attractive asset class. The acronym TINA (There Is No Alternative) was even coined. The question was to be invested in equities at all costs rather than how to invest in equities. This contributed to what may be called the golden age of passive management. Index funds and ETFs allow you to be quickly invested in the markets to capture the rise of stocks. Their success has been phenomenal over the last decade. A Morningstar study calculates that, in the US market, the market share of passive management has increased from 16.8% in 2012 to 35% today. Assets under management have multiplied by 5 in ten years.

An innovative version of passive management, thematic funds, also show exceptional trends. These funds have tripled their market share over the last decade to reach 2.7%. Assets under management have grown from $71bn (2011) to $800bn (2021). This success is all the more interesting as the performance of these funds is not satisfactory. A study has shown that these funds underperform the market by 4% per year over the 5 years following their launch.

QE has led to a harmful lack of discernment. On the one hand, by contributing to the rise of passive management that buys what has gone up and sells what has gone down, it has encouraged the emergence of financial bubbles. On the other hand, by allowing the implementation of a zero cost of capital, it has led to all sorts of consequences that are sometimes only visible when it is too late.

Opposing themes for the new decade

One thing is for sure: the new decade is starting out very differently, even the opposite of the last one. Where the ECB fought deflation for 10 years, it must now fight to keep inflation at bay. From QE, we have moved to a cycle of rising interest rates that increases the cost of capital and puts pressure on the profitability of companies. The issue of refinancing is back on the agenda, whereas it had disappeared since 2012. The possibility of a recession is now certain; the question is how deep it will be. The recent violent movements in currencies (collapse of the pound against the dollar, significant weakening of the euro-dollar) are another example of a sign of market dislocation. Many had foreseen that the end of QE would not be smooth, and the current phenomena are proof of this. While the markets have been operating on a large oxygen tank for 10 years, they are now in apnea.

‍

A relevant return to active management

The margins of safety are very small, and discernment is the key to investing. Over the next decade, it is very likely that the equity markets will not rise in a straight line, so we must be selective. Active management is regaining its relevance. Selecting companies that have no financing problems, that are not losing money, that have a profitable business model and that are not overvalued is the job of active management. All these companies that are indebted, unprofitable, with an unproven model and excessive valuations have often seen their stock prices rise during QE. We must now avoid them and make real investment choices. Only active management can do this, because passive management does not "choose".

‍