When does active management work? - check the rate environment

Nomura has generated some provocative work on the value of active management. A lot of the value is affected by whether the analysis includes fees, but within the work are little nuggets on how investors should look at active management. It may be more effective to think about active management within the context of the macroeconomic environment. When rates are rising, active management works, when rates are falling, index investing is more effective.

When the rates back-up, the discounted value of cash flows will decline, so a broad set of stocks bundled in an index may underperform a portfolio that is actively selected. What this tells us is that if the interest rate environment is expected to turn up, allocations to active managers make sense. Obviously, this also applies to alternative investments. Hedge funds are active managers to the extreme, so looking for alpha producers in a rising market should maximize their benefit. This could a good reason for why there is a such an interest in global macro and CTA's. Simple beta exposure may not be prudent in a changing rate environment.

This result could a monetary policy effect, it could be a discounting or leverage effect, or a changing inflation effect. More work on this issue is warranted, but the evidence and theory seems to be consistent with the idea that active management is beneficial when rates rise and monetary policy may be turning higher.