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Justin Lenarcic , Global Alternative Investment Strategist
As Cycle Ages, Active Strategies May Be a Comeback Kid
The Cyclicality of Active and Passive Investing
It is important to consider that there is cyclicality for active investing. The most essential requirement for active management is the ability to distinguish between fundamentally strong and weak companies (and their securities), and for positive returns to be generated from taking long and short positions in those companies. Differences in capital structures, revenue, margins, and growth trajectories, for example, become more apparent later in the cycle, when both interest rates and inflation historically have risen. This is a key reason why active strategies have historically outperformed passive strategies leading up to, and during, recessions (Chart 1).
What it May Mean for Investors
In our opinion, framing the diversification debate as either active or passive falls short of truly understanding how the two approaches interact with each other. Instead, we believe, the decision should be around what percentage of a portfolio should be active relative to passive, given where we are in the market cycle. One can certainly acknowledge that the recent market environment has been more conducive to passive strategies than active management, but the critical question is whether that scenario is sustainable as the cycle matures and whether diversifying with alternative investment strategies such as those employed by hedge funds potentially become more valuable for a portfolio going forward.
All investing involves risk including the possible loss of principal. Different investments offer different levels of potential return and market risk. You should be aware of, and understand, all risks associated with a particular investment. Bear in mind that a diversified portfolio does not guarantee a profit or protect against loss including in a declining market.
Alternative Investments, such as hedge funds, are not suitable for all investors. They are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. While investors may potentially benefit from the ability of hedge funds to potentially improve the risk-reward profiles of their portfolios, the investments themselves can carry significant risks. Hedge funds trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods which can result in adverse consequences for the investor and the fund. There is no guarantee any hedging strategy will be successful or not incur loss.
An index is unmanaged and not available for direct investment.
HFRI Fund Weighted Composite Index. A global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. Dollars and have a minimum of $50 Million under management or a 12-month track record of active performance. The HFRI Fund Weighted Index does not include Funds of Hedge Funds.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
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