MASTERCLASS: Emerging Markets - August 2020
July 30, 2020
Jenna Dagenhart: Welcome to Asset TV. This is your active management masterclass. We'll talk about some of the opportunities and challenges facing active managers during the coronavirus pandemic as well as selection strategies, market volatility and more. Joining us now are three expert panelists, Michael Clarfeld at ClearBridge Dividend Strategy, portfolio manager at ClearBridge Investments. Tom Rollins, equity institutional portfolio manager at Fidelity Investments and Bryan Whelan, fixed income portfolio manager at TCW. Everyone, thank you for joining us. And Michael, to kick things off with you, how would you define active management?
Michael Clarfeld: At ClearBridge and with Dividend Strategy, our approach is about the type of outcomes and objectives we're trying to achieve for our clients. And what we mean by that is that with our Dividend Strategy product, the approach is not so much about how are we going to do compared to a benchmark, but can we create a portfolio, a diversified portfolio of high quality companies with an attractive yield today that will compound income growth over time and do it in a low risk conservative manner? And the importance of this is that while obviously it's important to measure everybody against benchmarks and to consider performance relative to the indices, we also have to remember what the objectives are that we're trying to achieve for our clients or the original purpose of investing.
Michael Clarfeld: Investors, while yes, they care about how they do against an index. What they're really trying to do is not compared to an index but try to save for retirement or achieve some longer-term financial objectives. And so what we're trying to do with Dividend Strategy, what our active management approach is all about is again to build a portfolio that's highly diversified from a risk perspective, that throws off an attractive current coupon, and it can compound returns and capital appreciation in a low risk manner over a very long period of time. Because the objective here is to help people save for retirement 10 or 20 years from now, and that's really what the focus is.
Michael Clarfeld: And I think you would contrast that with passive, which I think we're all aware is becoming such a bigger and bigger part of the investment world. And there, the real focus is less about achieving some sort of long-term objective that's stated up front and more just about mirroring or copying an index or a benchmark. So, it's really quite different, and I think interesting to talk more about as we go forward. I think the differences between active and passive management become even more relevant and are brought into greater relief at turning points or points of volatility like we're seeing now in the world and in the markets.
Jenna Dagenhart: And Tom, turning to you, what are some of your goals at Fidelity?
Thomas Rollins: Thanks Jenna. At Fidelity, we're seeking to deliver value for our clients in a number of different ways. Our retail customers realize this value on a daily basis from the service they receive through our investor center network, phone reps, through our website, mobile apps. On the asset management side of our business, we don't believe that active and passive investing is necessarily an either-or proposition. So, we really want to provide our customers with choice. So, with that in mind, we've offered our customers access to low cost index funds for more than 25 years in addition to a lineup of low-cost active funds. And the active funds, the active management is really a core part of Fidelity's heritage. We strongly believe that active is alive and well, and we think we can continue to deliver value to shareholders of our active portfolios over time through a number of different strategies that are available on our platform.
Jenna Dagenhart: Bryan, we've seen growing interest from investors in passive fixed income strategies but nowhere near the level of equities, what do you attribute that to and why are investors perhaps better served by actively managed portfolios in fixed income?
Bryan Whalen: Sure. First, thanks for having us. First of all, what I'd say is I don't think investors are necessarily better served by active fixed income management versus passive. First thing we want to kind of remind our clients to do is to think about what type of fixed income strategy or portfolio they want. There's been a lot of deviations and growth into different parts of the fixed income markets that some of them may not behave like traditional fixed income should. I think a client, an investor should first determine what type of fixed income product they want. And then within that, can they find an active manager who over the long term deliver good risk adjusted returns over the index? And if you do that, then maybe you can make the active versus passive.
Bryan Whalen: I think more at the kind of theoretical level on paper, it's probably easier to make the case for active fixed income versus active equities. Not to say it can't be done in either or, but on paper, what we have the advantage in fixed income is that while an index we're looking at may have a few thousand issuers or a thousand CUSIP, the opportunity set is in the hundreds of thousands. Meaning that if you're an active equity manager, you may be benchmarked to something with 100, 300, 500, 3,000 different stocks. And then you can kind of fine tune your portfolio based upon your view and fixed income.
Bryan Whalen: We have hundreds of thousands of CUSIP we can choose from. We have the ability to go into sectors that are hundreds of billions in size that aren't even in our index. And then even at the issuer level, let's say like a JP Morgan or a United Airlines, while they may have only one equity outstanding in the fixed income markets, we may be able to get exposure to those issuers at the senior level, at the subordinate level, at the holding company, at the operating company, at the secured, at the unsecured. We may be able to take exposure to the 3-year part of the curve versus the 30-year part of the curve. There's a lot of opportunities.
Bryan Whalen: Now, saying that, that gives an active manager the ability to outperform, but those are also tools that could work against you if you make the wrong decisions.
Jenna Dagenhart: With great power comes great responsibility.
Bryan Whalen: Yes, that's right.
Jenna Dagenhart: And Michael, people love to debate active versus passive investing. It's already come up here. What makes active management unique in your opinion compared to passive?
Michael Clarfeld: I think as the other panelists have mentioned, in today's world, it's not a question of either or right. Clients are using both and for different things and appropriately so. What we believe active management is so important is particularly times like the one we're in right now where the trends that we've had for many years are changing. We still don't know exactly how all these things are going to play out. But you have big uncertainty in the world from the pandemic. You have big uncertainty in the world from changing central banks and government spending. You have big political risks and social unrest. And as Bryan said about something different, but we have the opportunity to make choices here about do we want to reposition meaningfully, do we think that the world ahead is going to be different than the world behind?
Michael Clarfeld: It's a very rich opportunity for active managers to make those decisions. Now, with those choices also comes risks. People could make the wrong decisions; it may turn out that the pandemic is worse than people fear or they're not nearly as bad or all of these things. There are so many different permutations to how things play out. But I think that the time we're in right now particularly underscores the importance of active management and the role it should play in terms of clients finding management firms and management teams who invest in a way that's consistent with their view of the world and the types of risks and approach that they're looking for with their investments.
Jenna Dagenhart: Tom, why active and why active in this kind of environment?
Thomas Rollins: Totally. I think Michael said it really well. I think that the tumultuous sort of period we've been through recently is a prime time for active management to hopefully shine. Again, I would emphasize active, passive is a customer choice. If you want average index returns, you can use index bonds. And as we know, those are very inexpensive. But if you want to do a little homework as an investor, you can find active managers who align with your risk tolerance and have the potential to deliver excess returns over time above and beyond those returns of an index. And again, at Fidelity, we strongly believe that we can outperform index funds through a market cycle, and we've done it. So, if you look at some Fidelity funds on the equity side, Contra Fund is a great example, it's managed by Will Danoff since 1990, benchmarked against the S&P 500.
Thomas Rollins: And since 1990, the fund has generated net fees returns of about 12.6% per year on average versus about 9.6% return for the S&P 500 over that timeframe. You've gotten about 300 basis points of excess returns from Contra Fund during that time period. 3% doesn't necessarily sound like that much in a one-year period, but 3% compounded over 30 years can make a really big difference to a shareholder and to the goals that they're likely to achieve over that time period. So, for example, if you had invested $10,000 in Contra Fund in 1990, it would be worth over $330,000 today. If you'd invested that same 10,000 in an index fund that even hypothetically had zero fees, it would only be worth a little over $150,000 today.
Thomas Rollins: So the compounding effect that active can have if you can generate performance over time can be really meaningful and help our clients achieve their goals. And I mentioned Will and Contra Fund because he's a very long tenured manager, but there are numerous other examples at Fidelity and other shops like we're talking today that have been able to show proven success in this area.
Jenna Dagenhart: Yeah. You really underscore the importance of managers there. And Bryan, even with actively management portfolios, there are big differences between managers. Can you describe your investment philosophy and process in relation to the philosophies and processes that you've observed in other managers?
Bryan Whalen: Sure. Jenna, we simply kind of call ourselves a value manager. Our belief of that means prices move more than facts, markets move in cycles, credit spreads move in cycles, and they tend to mean revert. And so, from a top down perspective, most important thing for us is to be disciplined to those cycles and position accordingly. And then we pair that with very disciplined bottoms up research. The large majority of our alpha over the last five, 10, 20 plus years has comes bottoms up. And so, kind of that bottoms up fundamental research on issuers, the disciplined view top down. We kind of pair that together to get an informed opinion of risk in the marketplace. And then we do what Michael and Tom do as well in their funds, which is we kind of pair the risk with the potential reward.
Bryan Whalen: And so in the fixed income markets, we're really talking about the premium in yield, the spread you get over comparable fixed income instruments that are considered [inaudible 00:11:28] like US treasuries. And so, there are environments where risk might be high. But if you're being compensated for it with a lot of reward, as an active manager, you're supposed to take a lot of exposure, a lot of risk at that point in time. And then there's other points in the cycle where risk may be high but spread payments are very low. And at the end of 2019 and the very early part of this year was a great example of that. There was a lot of risks in the marketplace, which isn't necessarily bad, but it was bad because the premium at which you were being paid to take that risk was very low. And so, we had our risk styled way down.
Bryan Whalen: There are other managers that kind of dial up and dial down the risk like we do. But I think generally speaking, what you'll find in the fixed income marketplace is a lot of managers view the kind of active license as the ability or the go ahead to always be long risk no matter what, kind of always having a higher yield than the index, always having it dialed up. And in later stages of the cycles, they tend to kind of justify to themselves, rationalize almost why the cycles are never going to end. And that works for a period of time up until the cycle does end or up into a period like we saw in March where that works against you. And all that extra alpha you generated for the past couple years is wiped out in a matter of days or weeks. Our view, it's important for an active manager to be willing not only take more risks than your respective index, but also be willing to take less in a period of time where you're not being paid for it.
Jenna Dagenhart: And with the coronavirus pandemic, what kind of challenges are active managers facing in this environment? How is COVID-19 impacting active managers? Tom, do you want to kick us off?
Thomas Rollins: Yeah, sure, happy to. I can't really speak for the whole industry, but at Fidelity, this has been a very tumultuous period just like it has been across the industry. We have been able to demonstrate meaningful outperformance for shareholders year to date on our equity platform. So relative performance for us has been strong. A few points about that that I think many active managers can offer and we certainly do Fidelity is we've benefited from having a really well-resourced firm in terms of technology and business continuity planning as well as investment expertise. On the business continuity front, we really didn't miss a beat when we all started working from home. And early to mid-March all of our systems are available remotely so we could maintain communications with each other, between portfolio managers and analysts, portfolio managers and each other. And also, our research team could maintain communication with the companies we're investing in.
Thomas Rollins: As a fundamental research shop that's really the bread and butter of our organization, meeting with companies, talking to management teams is a critical part of our analysis. We usually in 'normal times' do this by visiting companies at their headquarters or having them into our office in Boston. Obviously, all business travel has been off the table, but we have been able to conduct these meetings via Zoom. That business continuity has been solid for us and has helped us maintain. In terms of the investment expertise. I think the scale of our research organization has also helped us recover roughly 2,000 stocks globally. And having a strong point of view on the companies, a strong sort of proprietary point of view I think has been helpful. As many company’s management teams have been pulling guidance and made sort of this massive business disruption that they're seeing, it's very difficult for companies or anyone really to predict what's going to happen over the short term.
Thomas Rollins: So we've been focusing on the long term and we have a pretty strong viewpoint on a lot of companies. So, we definitely haven't been flying blind here. Another thing that's helped, I think, and I'd be curious for the other panelists' take on this as well is it's helped us on the equity team to have the fixed income and high yield teams within Fidelity to leverage as well. So particularly as we go through periods of stress like this where a lot of companies are facing liquidity crunches on their balance sheets, it really helps to have those fixed income specialists to really dissect the balance sheets with us and help us understand who can make it through the short term here.
Jenna Dagenhart: On that note, I'm going to pass the mic over to you Bryan talking about fixed income.
Bryan Whalen: Biggest risk for fixed income right now is that this isn't a V. If you look at the riskier parts of fixed income like leveraged finance, high yield leverage loans, emerging markets, and maybe subordinated risky parts of the commercial mortgage backed market and the more residential mortgage backed market, it's all price [inaudible 00:16:20]. To simplify the way investors or institutional investors are approaching, asset managers are approaching the fixed income market right now, it's one. The first question is, do you have the balance sheet? Do you have the liquidity to make it to the end of the year? And if the answer is yes regardless of whether you had liquidity going into this or whether you kind of built up a liquidity debt issuance, as long as you check that box, basically they're willing to then kind of assume that 2021 is going to look like 2019. And then the conversation's more traditional to a company is about, what's your market share going to be and your product offerings and things like that.
Bryan Whalen: If this isn't a V and 2021 from a growth perspective and earnings perspective is a fraction of 2019, we're going to have to have a repricing of risk. And the reason for that is that this kind of gap, this 2020 gap that investors just want to make sure you have the money for. A lot of these companies have acquired this money by raising debt, by selling more debt. And I'm just going to remind everyone, we kind of had a debt problem coming into 2020. Leverage ratios at both investment grade and high yield companies were already at all-time highs. It's a little bit of a kind of hair of the dog. We basically solved the current liquidity issue with more deb, so solving a debt problem with more debt. And if this economic contraction let's just say is a little worse or far worse than what's priced into the markets today, at least the risky parts of the fixed income market, we're definitely going to have a period of time where we're going to see volatility pick back up like we saw in March and April.
Jenna Dagenhart: Essentially adding more fuel to a fire that was already burning.
Bryan Whalen: Exactly right. Yep.
Jenna Dagenhart: Michael, anything you'd like to add to that?
Michael Clarfeld: Yeah. I think we would agree with a lot of what Tom and Bryan have said in the sense that with the scope of the rally that we've had, the market seems to be pricing in some pretty positive outcomes in terms of how quickly things get back to normal and maybe how quickly we have some therapeutic tools for dealing with COVID. And we hope that that's right, but there does seem to be some risk there if that isn't the case. Sort of similarly within equity markets is what they're thinking about on fixed income side, it's a focus on as we're putting together our investment cases, it's how do we think about the short term in terms of navigating this period of volatility and choppiness and uncertainty, and then the longer term. And for many companies, I mean, you can break it down into there's a handful of companies who have really very little impact on what's going on.
Michael Clarfeld: If you're Verizon, for example, everybody's still using their cell phones, hasn't really changed their outlook. There's a whole host of companies who have short term impacts that seem pretty significant, but longer term we don't have a whole lot of doubts that they will ultimately return to something like they were before all this and that they have the financial wherewithal to get to the other side. And then there's a third bucket of companies that we're not sure at all what business looks like on the other side, and can we get there? Again, the market has bounced so quickly. I think it caught lot of people by surprise at the bottom, and now I think people are having the opportunity to reposition in light of what's priced in which seems to be a fairly benign scenario, which again, we hope is the case. It may turn out not to.
Jenna Dagenhart: Yeah. The stock market seems like it wants to make this a V shaped recovery.
Michael Clarfeld: Certainly does.
Jenna Dagenhart: And Michael many active managers have underperformed the benchmarks this year. What do you think that is?
Michael Clarfeld: I think in large part it's because of the continuation of the trends that we saw that were in place before the downturn. I think we see it all over the place in terms of financial news that talk about how narrow the stock market is, how much of the indices are made up now of these platform companies that are absolutely wonderful companies from a financial return and growth perspective, the Amazons of the world, the Googles, the Microsoft, Apple, Netflix and go on and on. And those companies have become such big parts of the index that in order to be overweight, in order to beat the index when those stocks are doing well, you have to have very large positions there. And those stocks have been very defensive so far in the downturn in large part because work from home may have even reinforced some of strengths these companies had.
Michael Clarfeld: And also because as people have gone to the safety trade, the safety trade has actually gone to areas that are sort of unusual or different than in the past. What's been unusual is that normally or frequently we would think that in a downturn the things that have been the leaders before may roll over the hardest because they seem to extend. And rather what we've seen this time around is that in this downturn, in the midst of volatility, people are flocking back even more to these internet champions. And there's parts of that that makes sense in terms of these companies have phenomenal balance sheets, tremendous cashflow, they're highly profitable. At the same time when we look inside the market and see things like how growth is priced relative to value, we see that that's incredibly extended, in some ways the market looks the most extended in those sorts of measures as it's ever been.
Michael Clarfeld: And so I think what's been challenging just to reinforce the answer is that the strengths of the indices have been driven by a relatively narrow group of companies that have done phenomenally well. And I think as long as that trend is in place, it's challenging for active managers to outperform against that. I think the opportunity here should present itself is to the extent that this really does seem to provide a turning point in the market and a shift in paradigm. What's worked for the last many years while it's tempting to think it will go on forever, ultimately it won't. And what's going to work in the future, and I think that's the opportunity.
Jenna Dagenhart: Michael, what would cause this dynamic to change for active managers to outperform?
Michael Clarfeld: I think, again, it goes back to some of the things I started with earlier in the program, which is just the tremendous amount of uncertainty. We go back to just on the health front, on the economic front, but fiscal and monetary policy on the political front, on the social unrest front. Each of these things in and of themselves would be big enough on their own, and then you throw them all together. And yet as you said the market wants it to be a V, and they're getting a lot of help in that regard from the central bank and from the government that is providing a lot of stimulus to the markets, which is the appropriate response.
Michael Clarfeld: What creates the opportunity for active managers is that people are still largely investing like it's February of 2020. Not entirely a for sure, not restaurants or airlines or hotels. But many of the trends that were in place back then have been reinforced. And I think the question, the jury's out, is this a real turning point and are we at a real point of sort of paradigm shift for capital market economy, political environment? But to the extent that we are, there's a real opportunity there and also a lot of risk.
Jenna Dagenhart: Tom, how have you been approaching all of the COVID market volatility?
Thomas Rollins: That's a great question. We have a number of different strategies that have been thinking about it in varying ways. We have been finding opportunities, and I think as we've sort of been discussing the V here, I think the ultimate question for a lot of companies, you've kind of developed this trade in the market of the COVID beneficiaries, which are sort of your growth momentum types of names. And then you have this other cohort, which is sort of the reopening trade, which are maybe more cyclical industries that are going to benefit as the economy gets a lift. But when you look at those more growthy companies that appear to be beneficiaries, I think the big question that we grapple with a lot of these, say an eCommerce company or a cloud software company that appears to be certainly a beneficiary now. The question is whether the lift they're getting is just a short-term lift that goes away or if they're really sort of pulling forward an addressable market that that is likely to grow over time.
Thomas Rollins: I think there are a lot of industries that you can apply that to, and we're taking a look at it sort of company by company. We are finding opportunities we think in businesses that maybe are performing well, that our COVID beneficiaries, but we think maybe aren't pricing in a sustainable advantage, that are only pricing in a short-term advantage. So that's sort of one area where we have been finding opportunities. We've also been finding opportunities in companies that have gotten particularly from mid-February to mid-March, that got severely dragged down, their share price has really dragged down.
Thomas Rollins: So for example emerging growth companies that were unprofitable or less profitable coming into that period just due to the fact that they were investing in their future growth, that cohort tended to sell off harder than others in the market, which kind of makes sense if you're unprofitable, you're looking at a non-profitable company and the economies is in shambles. It seems like that unprofitable company can have a difficult time going forward. But with stock prices for a lot of these types of businesses down over 50%, 75%, this is an area that we have found opportunities to invest in companies that we felt did have the liquidity to get through the short term and have the long-term business models where the investment thesis over the long-term is still intact. And although it's a gray area, really sort of understanding what our economy looks like on the other side of COVID, there are cases where we have conviction that their business models will be strong over the long-term.
Jenna Dagenhart: And Bryan, could you lay out some of the most prominent risks and opportunities that you think currently exists for fixed income investors? In light of that, how are you positioning your portfolios?
Bryan Whalen: Well, I think I'm going to kind of go back to the V but giving a different angle on more specifics. I think the risk here is that what we went through from an economic perspective in March, April, and May was really kind of massed over by both fiscal and monetary action. I've found this statistic amazing, consumer disposable income in the second quarter of this year will be higher than it was in 2019. And clearly, a lot of people have lost their jobs, et cetera, but the combination of jobless benefits as well as the payments from the CARES Act actually increased disposable income. We've also been in a period where we've had a lot of forbearance whether it's personal rent, mortgage payments, whether that be kind of commercial rent, things like that.
Bryan Whalen: And as we go through the months of July, August, September, a lot of that's going to be kind of weaning off. The risks are that not only is it not a V shape, but when we get into the later fall at the end of this year, we may be entering a period of time where investors, whether it be equity investors or fixed income investors, what they were hoping for maybe doesn't come to pass and that you start to hear earnings calls in the fourth quarter looking back at the third quarter. And companies are starting to make investors aware that, you know what, maybe things weren't as good as you thought they were in June, in July, in August because we've had this kind of fiscal monetary overlay that made things look a lot healthier than they really were.
Jenna Dagenhart: And to your point about how much money people have on hand in 2020 versus say 2019, it's not good if people are clinging to cash, but we did see household savings rates go up quite a bit this spring too.
Bryan Whalen: Yeah. Without a doubt. I'm not saying consumer spending since what they actually spent was up year over year, but it wasn't nearly as bad as I think it could have been. Yeah, that's the primary risk in our minds, particularly given the fact that the market is almost priced for anything other than that.
Jenna Dagenhart: And Michael, where are you seeing opportunity from the recent sell off?
Michael Clarfeld: I think one of the areas that has surprised us a bit in terms of pricing opportunities is actually in regulated utilities. And what surprised us is that regulated utilities are something that you think will be very well positioned for this type of environment in the sense that there should have relatively less economic sensitivity, there's a predictable return structure. And many of these companies have very visible secure growth rates in the future from sort of long-term plans they've submitted to the regulators had approved. And nevertheless, utility sold off very hard in the downturn. And so, from our perspective, again, going back to echoing much of what's been said so far, the market seems to have this very benign view of how things are going to play out.
Michael Clarfeld: And from a risk adjusted perspective, it strikes us that some of these regulated utilities provide a pretty attractive risk adjusted return and have the ability to get a 3 to 4% upfront yield and earnings growth in the 6 to 8% range for the next many years. And we look at that and say the combination of pretty mixed upfront income, 6 to 8% growth with a pretty low risk profile given all the risks and uncertainties we're talking about seems like a pretty attractive place to be.
Jenna Dagenhart: Great. And we've talked a little bit about some of the economic stimulus measures. Bryan, what are your views on the fed's actions, and how do you think they'll impact bond pricing in the intermediate to long term?
Bryan Whalen: The feds have done everything we thought they'd do times 10 to be quite honest, it was amazing. This is a whole other topic. At least in the fixed income markets, we have been kind of pounding the table for years about the risk of liquidity. And a lot of large, daily, public mutual funds were taking a lot of risks that may lead them to a point where they couldn't meet the redemption of liquidity demands they have promised of clients. And that's really what we were seeing in March, liquidity was in the bond market in March, was worse than I'd ever seen it, far worse than the fall of 2008. And it took kind of incredible actions by the fed to effectively fill the hole in liquidity that Dodd Frank and Basel and other regulations effectively kind of extracted over the past six or seven years.
Bryan Whalen: So our view of the fed monetary policy, how it impacts bond pricing and the kind of short, intermediate, and long-term. And way we like to think about it is the fed effectively, it's built its castle, it's built its walls around the castle and has decided which asset classes are going to be inside and which are going to be outside. And inside, easy examples, directly examples in terms of what they're doing in QE, agency mortgage backed securities, investment grade corporate bonds inside five years. They've effectively waved that in. So even if this isn't a V and we enter a very long and dark kind of recession, I don't think we're ever going to see the spreads we saw back in March. Those types of spreads on agency mortgage backed securities, investment grade corporate bonds, it's not going to happen again because the fed will just keep throwing enough money at it.
Bryan Whalen: So the question for fixed income investors, active managers is who's on the inside and who's on the outside? So, from our perspective, where you don't want to take risk right now are parts of the fixed income market we view outside. And that's a big part of the high yield market, that's risky parts of the commercial mortgage backed market, the residential mortgage backed market. Those markets will not get direct fed support, and they may have to actually face and be priced to fundamentals that may be far worse than priced in the markets today.
Jenna Dagenhart: Michael, what do you make of the powerful market rebound? And do you think that stocks could be getting ahead of themselves?
Michael Clarfeld: I think we do think that there's a real risk that's stocks are ahead of themselves. We're not surprised that there was a rebound, the amount of negativity that was pricing at the bottom of March was severe. And the amount of stimulus we've seen both from a monetary and fiscal policy perspective has been sizeable, and we thought would work in reversing much of the downdraft we saw. But yeah, we do think that the markets are ahead of themselves. It seems like in many cases it's just pricing in essentially a best-case scenario. And I think the answer as to why again is not surprising, is the tremendous amount of liquidity in the fixed income markets that's spilling over everywhere else from central bank actions.
Michael Clarfeld: We're hopeful and optimistic that what's priced into the markets may actually become the reality and all of us can get back to our normal healthier lives quicker. But I think we're cognizant of the fact that the risk is very real, that it's not. And that from a restored perspective, the time to take a lot of risk is when you're being paid to, and right now it doesn't feel like we are.
Jenna Dagenhart: And Tom, we touched on this a little bit earlier. But historically speaking, when do active managers tend to prove their value?
Thomas Rollins: If the market has low dispersion of returns, in other words, if all stocks are trading in lockstep with each other, it's impossible for an active manager to outperform. So, what an active manager needs are lower correlations between stocks, between industries in terms of their stock price movements and higher dispersions of returns. For the last, I don't know, decade or so really coming out of the global financial crisis until February of this year, I think the dispersions of returns were generally lower making it more difficult for a lot of active managers to differentiate from their indexes. In this most recent period of volatility, we've certainly seen higher dispersions of returns, which does create more opportunity for active managers to outperform.
Thomas Rollins: Again, as my co-panelists have identified, it also creates more risks out there, more risk of underperformance. I think it is an opportunity for the really good active managers to differentiate themselves. One thing that gets talked about often is that active management should do better in down markets. In other words, protecting their client's assets better in down markets. And I think that might be a little bit too blunt of an analysis. At Fidelity, our mantra has always been that stocks follow earnings. And over time, if you can be directionally correct on which stocks are going to grow their earnings faster than the market, you can invest in those names. And over time, that's led to a significant out performance.
Thomas Rollins: But there are shorter periods of time, sort of air pockets in the market when stocks are not rewarded for earnings growth. And those often coincide with big drawdowns in the market where investors really care more about safety than earnings growth. And those can be difficult times for active managers like ourselves. But as long as we stick to our long-term objectives, stick to our process and adhere to our risk controls, we do feel like the stocks following earnings mantra and the talented investment research team we have should lead to outperformance opportunities over time.
Jenna Dagenhart: And Michael, during these sharp drawdowns like the one we've just experienced, how do you assess the impact on individual companies and sectors? Can you walk us through your stress testing approach?
Michael Clarfeld: Yeah. Importantly, I think the work we do here starts long before the drawdowns in the sense of hopefully picking companies, industries, and sectors that are well positioned to withstand big downturns in the economy, in the markets. And that starts with things like evaluating balance sheets and capital structure, free cashflow, sustainability of dividend payout ratios, and sort of economic sensitivity and cyclicality of the business. So, again, importantly, that starts beforehand. Then obviously during the downturn, you're re-evaluating those things. I think one of the things that's been so interesting and surprising and challenging, and painful about this downturn is it's unlike anything we've seen in any of our lifetimes in the sense that certain things we didn't realize how much risk there was because nobody ever thought that the entire country would have to stay home for three months and shut down things.
Michael Clarfeld: So interesting things like gasoline demand, which historically has been very stable. And I think in the worst downturn you've ever seen, it only been down 1 or 2% before. So very stable utility like gasoline demand I think in April and March was down 30 or 40%. And so, all of a sudden, a business, if you were a pipeline of gasoline, for example, your worst downturn you've ever seen in 40 years had been 1 or 2%, and all of a sudden, your business is down 30 or 40. That's something. And again, you think about things like restaurants. And we thought, well, in a downturn, your pop sales might be down 2 or 3%, you didn't think that restaurants would just be closed. We didn't own a lot of restaurant service, so that's not particularly specifically to us, but just as an example.
Michael Clarfeld: There's presented risks that people had never really expected. So, I think that has been one of the [inaudible 00:38:18]. So again, the work starts beforehand in terms of the kind of businesses you want on over cycle by evaluating balance sheet, capital structure, cyclicality of business, economic sensitivity. And then during the downturn as things are playing out in real, you're reassessing in light of this new risk environment that we're in of people staying home and what all that means and socially distance for an extended period of time, reevaluating that on a business by business basis. And again, it focuses most intensely in downturn in the crux of it on sort of balance sheet and financial sustainability. And then thinking longer term about what a business looks like in this new world.
Jenna Dagenhart: This new unprecedented world that we are living in. Bryan, active bond managers obviously watch credit ratings closely. How much credence do you put in the rating agencies' ability to give useful guidance here?
Bryan Whalen: I don't think they have any more insight than anyone else with the access to the same information. They have informed opinions, and all of us, Michael, Tom, me as portfolio manager, you're supposed to listen to as many informed opinions as you can. It doesn't mean you agree with all of them, but you take it all in. And so, from a kind of a fundamental, what do we think of this issue or this bond? We listen to them, and we'll take in as much as we can. We have our own analysts with our own opinions as well. Where the rating agencies are very powerful though is with regards to the technical supply pressure, and really what I'm referring to here are downgrades. People like to simplify the bond market into investment grade and below investment grade.
Bryan Whalen: And when an investment grade company, their rating is downgraded to below investment grade, there's often a lot of selling pressure, whether it be retail, institutional investors, a lot of them can only hold investment grade companies. And I will tell you if this turns out to be a more traditional de-leveraging event, a longer recession that's priced in right now. Based upon our view of the leverage in the market, how downgrade activity has occurred in prior recessions and kind of prior to de-leveraging periods, to date we've probably only seen between 10 to 20% of the downgrades that are yet to come. So, as a portfolio manager in fixed income, you should be listening to the rating agencies, but particularly with regards to what they may do and who they may downgrade to below investment grade because that will have a material impact on the pricing of those credits.
Jenna Dagenhart: Tom, what's your approach when it comes to large cap growth strategies?
Thomas Rollins: Our growth team at Fidelity tends to be really focused on finding opportunities where the duration of growth is being under appreciated by the market. So, we're trying to look out three to five to seven years where we think earnings and free cash flows can be over that period of time. We're not making a lot of one or two quarter trades; we tend to be invested for the long term. I think we spend a lot of time looking down the cap spectrum at emerging growers on the growth side. And these can be profitable investments to make in some of these smaller, mid cap growth stocks. They can also by doing the work and understanding their business models and their products, it can shine a light on industries where they may be disrupting incumbents.
Thomas Rollins: As we're all sort of managing portfolios in a relative game, that can be just as important to identify index constituents to avoid, for example. But really what it comes down to is that duration of growth for us and trying to find companies often that are exposed to secular growth tailwinds, growing addressable markets, but also have the business models to maintain their share of that addressable market or hopefully grow it over time. Just being a cloud company, for example, doesn't guarantee success. You need the product and the discipline to outperform over time.
Jenna Dagenhart: Michael, how do you apply your active approach to selecting dividend paying stocks? Do you prefer to focus on dividend growth or current yield?
Michael Clarfeld: It's a balance of both, and it's as much an art as a science. And so, what we're trying to do with our portfolio is to provide an attractive upfront yield. But the real emphasis is on marrying that with dividend growth and powerful dividend growth. We think the real benefit of equity income investing is not the current yield, but the ability to grow the income over time. And so, for a very long period of time, our portfolios have been able to grow their dividends at a high single digit rate, which we think is really powerful in terms of what that can mean compounding of income over time. Another key part of investing and being a dividend investor is focusing on the sustainability of dividends. So, we spend a lot of time evaluating that in terms of what's the company's payer ratio, what's their free cashflow generation look like, and what's the balance sheet look like to ensure that in a downturn they'll be able to continue to pay and even grow their dividend?
Michael Clarfeld: And I think we've seen that, and [inaudible 00:43:33] that to date you know. So, in the first half of the year through the downturn, I think about 60 companies in the S&P 500 have cut their dividends. And actually, out of the 500 in the S&P 500, only about 400 of them paid dividends coming into this. So about 15% of either cut or skipped their dividends. In our portfolio of 50, we've had one, which is Disney who skipped their recent dividend payment. And it just goes to show the uniqueness of this downturn that the one company in our portfolio that suspended its dividend was Disney. If you would ask to six months ago to rank companies at risk of not paying a dividend in the next downturn, Disney wouldn't have factored on the list, very high-quality company, great balance sheet, a lot of recurring revenues. But when you shut theme parks, you shut movie theaters, you shut sports, all of which we didn't really think as being a high likely of coming to be, it was the prudent thing for them in the depths of this to do that and then revisit in six months.
Jenna Dagenhart: Yeah, no one saw this coming as you mentioned. Bryan, you talked a little bit earlier about just the sheer volume of options that bond investors have. Are you surprised at the number of high yield offerings and the investor appetite for those offerings with the lack of clarity going on at the moment?
Bryan Whalen: Yeah, we're shocked. It's kind of reminiscent of a lot of behavior we saw in the last few years. But high yield bond markets right now, investors they're acting like they've been partying all night with a case of Red Bull, it's incredible, completely ignoring the fundamentals. And part of me says you can't blame. For the better part of the last eight years, nine years, you haven't been paid to do the fundamental work kind of positioning accordingly, you've been paid just to bet on the fed. Basically you're being paid to buy these dips because regardless of fundamentals, the fed comes in and saves the day and they've done so again. And eventually, and I think Michael said before something along the lines, eventually the kind of fundamentals will write themselves, and maybe this time will be different. But right now, investors are kind of just behaving like they've been trained to for the last 9 or 10 years, which is push fundamentals aside, focus on the fed, follow the fed, they'll support all markets all the time.
Jenna Dagenhart: Michael, why does focus on dividends make sense in such an unsettled environment?
Michael Clarfeld: Dividends investors won't be surprised to hear this, but we believe dividends are always important and should always be a core part of equity investing. But really right now, I think there's a few reasons. I think the first would be, number one, just from an income perspective with interest rates as low as they are, the yield you can get from high quality equities is very competitive with what you can find elsewhere. First is we think there's a relatively attractive income story there, the spread of high-quality dividends over treasuries is close to as high as it's ever been. I think the second thing is that with the tremendous recovery we've had in the stock market and with our expectation, absent the short term fill up the economy is going to get from reopening, we expect a generally lower growth environment in the years ahead than we had before, which wasn't a particularly great growth environment as a starting point.
Michael Clarfeld: So with pretty full stock market valuations in a relatively lower growth global economy, we think that more and more of the return you get in equities from here is going to come from the income component. And then the last piece would be to the extent that any of us are proven right and that the markets become more volatile and start to reflect more of the challenges and less of just the liquidity support, dividend should provide some support in a choppier market to stock prices in terms of valuation support and downside protection. So, I think there's a whole host of good reasons to really emphasize dividends now even more than ever.
Jenna Dagenhart: Tom, anything that you would like to add about growth-oriented funds?
Thomas Rollins: We've kind of talked a lot about stocks having this V recovery, which has been huge, and it's benefited a lot of growthier names to be sure. There remains this sort of back and forth, if you will, of is this a short-term blip for some of these companies or is this really pulling forward some of their long-term growth? I think it's been pretty well covered in the media. But it is an important point that this pandemic that we've been going through certainly is pulling forward some of these big secular trends, cloud computing, eCommerce, artificial intelligence to name. Buyer technology is another area that is certainly looking more in favor now. As the secular trends that we've known about for a long time are accelerating, I think it's important not to ignore potential beneficiaries there over the long term not just during the short term that we're in right now.
Jenna Dagenhart: And Bryan, do you have any advice for intermediaries or investors who are performing due diligence on fixed income managers, any specific items worth looking for?
Bryan Whalen: Yeah. I talked to earlier, you asked me a question about our philosophy and then kind of walked you through the value philosophy. The first thing I tell investors is that, look, that's our philosophy. And it doesn't mean it's the best one, but it's ours, it works for us. And it doesn't mean others can't use different philosophies or strategies. Maybe they're momentum based. But if they executed well and they're disciplined to that, then that's great. So, I think the first thing is kind of understand with a lot of strategies and what you really just want more importantly than anything is consistency to those strategies. And consistencies, hopefully you've seen it over multiple cycles. And once you can determine that, then you can kind of take the next step and say, you know what, maybe I want a little of both.
Bryan Whalen: Tom mentioned something earlier about how it shouldn't just be passive versus active. Maybe there's a place for both in your portfolio. As it comes down to just active management at least within fixed income, I can tell you, I don't necessarily think there should only be one type of strategy that's best for everybody. Sometimes it's good to have a balance. And if you have that balance, over time I think you'll hopefully get a good risk adjusted return over a particular index. And maybe it'll be smoothed out by having a couple of different types of strategies within your portfolio.
Jenna Dagenhart: And finally, as we start to wrap up this panel, I want to end by looking forward, where do we go from here, Tom? Million-dollar question, I know, I know.
Thomas Rollins: Right, right, million-dollar question. It's very difficult obviously to foresee where we're going from here. So much is dependent on the help we get from the healthcare community in terms of the vaccine. It's yet to be determined how to be economy recovers or how long that recovery takes. What we're really focused on is trying to identify business models that are less dependent on some of these macroeconomic variables. Now, every stock is going to have some correlation positive or negative with these macroeconomic variables. But over the long term, we will continue to focus on identifying business models that have their destiny more in their own control. And that's sort of the recipe we've used over time, and that's what we'll continue to do.
Jenna Dagenhart: And what does the future of active management look like to you Bryan?
Bryan Whalen: First you got to tell me where we're going to be in December and what the world's going to look like.
Jenna Dagenhart: I wish I could tell you that Bryan, but no promises.
Bryan Whalen: Maybe next time. Maybe what I'd say, is this, is that consistent with late cycle, what we've seen in fixed income. I touched on this earlier is that we've seen a lot of types of strategies that are maybe a little different than traditional core strategies. And a lot of them had to do with taking more risk. And of course, because that was during a period of time where due to financial oppression, low yields, investors were starved for that yield. And to get more income, more yield, they were taking more risks. Things like leverage strategies, ETFs that are levered or maybe even kind of delving into areas like in the private credit markets versus the public markets within fixed income. That was really growing over the past few years. If this isn't a V and we see more volatility ahead, I suspect over the long-term we'll probably see a shakeout in these kinds of peripheral like strategies within fixed income and a lot of investors come almost kind of closer to home back to more traditional core plus type products.
Jenna Dagenhart: And finally, Michael, where do you think the industry is headed? Any trends that you're watching with dividends or active management that you'd like to highlight?
Michael Clarfeld: I think in the near term, I think sort of maybe two trends. I think the trend that we've seen towards passive and indexing I think continues. That's been ongoing for a very long time, and we certainly think it'll run further. As we've talked about before, we don't think that it's a one or the other, investors have to choose, there's places for both. I think one of the things that's become interesting about that trend is that there's some old proverb, and I don't mean to sound dismissive about it because I don't. What the wise man does at the beginning, the less wise person does in the end.
Michael Clarfeld: And with indexing and passive, again, it's not a negative, but we're getting to a place, I think we've recently got to a place where roughly half the money in the stock market is passively managed, tracking and index. And I think longer term, it raises real questions for capital markets and society about when that happens. I don't think we're necessarily near sort of judgment day for that when we'll find out. But increasingly the more and more the society allocates capital like that, it could have longer term ramifications. It very well may not, but it could. And I think that's a question that bears watching. I think the other thing we've been focused on is alternative asset managers. The lower term world that we're in particularly on the institutional investor side has made it more and more challenging for them to hit some of the [inaudible 00:53:46] and targets. And we're seeing investors shift more and more money in the alternatives.
Michael Clarfeld: One of the interesting things, and one of the things we've been able to play in that regard is that increasingly some of the alternative asset managers are publicly traded and traded to corporations. So, we've been able to invest there. Well, it's been a great run so far, we actually think there's a long way to go. We think that retail investors are just starting to get access to that alternative asset management product. And while we don't ever think that will be the majority by any stretch of retail investors' portfolio, there's a huge pie out there of retail investors asset allocation that really going from a very small starting point could become much more meaningful and see a lot of money flow into alternatives. That's one other things we're looking for.
Jenna Dagenhart: Well, a lot to watch moving forward. Thank you so much everyone for joining us.
Michael Clarfeld: Thank you.
Bryan Whalen: Thanks Jenna.
Michael Clarfeld: Thank you.
Jenna Dagenhart: And thank you for watching this active management masterclass. I was joined by Michael Clarfeld, ClearBridge Dividends Strategy, portfolio manager at ClearBridge Investments, Tom Rollins, equity institutional portfolio manager at Fidelity Investments and Bryan Whalen, fixed income portfolio manager at TCW. And I'm Jenna Dagenhart for Asset TV.