Rising Rates and Volatility

A More Positive Environment for Active Value Investing

July 2018

American Century Investments views passive and active strategies as complementary tools for achieving successful investment outcomes. In his 2017 paper on the active/passive debate, American Century Co-Chief Investment Officer Victor Zhang observed that given the complexity of portfolio construction and achieving investment objectives it would be “shortsighted to exclude half of the investment tools at your disposal out of hand.”

Active and passive approaches offer advantages and disadvantages, each rotating in and out of favor as market conditions change. The current rising rate environment offers a good case in point. In this paper, we put the magnitude and duration of the current period of passive outperformance in historical perspective and discuss the role of interest rates in active/passive cyclicality. We then address why we believe rising rates may place passive investors, particularly passive value investors, at a structural disadvantage.

Active and Passive Performance Is Cyclical

Active strategies have historically outperformed when interest rates are rising and market conditions are more volatile. Passive approaches tend to outperform when rates are stable or falling and equity market performance is strong and upward trending.

Cash Flows Follow Performance

Supported by historically low rates and low volatility, the most recent extended period of passive outperformance resulted in massive outflows from active strategies to traditional passive vehicles and smart beta ETFs tilted toward income. This helped sustain the passive cycle and drove up valuations in rate-sensitive corners of the market.

Rising Rates Might Be a Harbinger of Change

The U.S. Federal Reserve (Fed) is well down the path to normalizing interest rates. Historically, shifts away from accommodative monetary policy have served as catalysts for increased market volatility, lower correlations, and changes in market leadership.

Passive Value Investors Are Overexposed to Expensive, Rate-Sensitive Sectors

The chase for yield in the low-rate environment following the Great Recession drove high valuations and larger value index weights in rate-sensitive sectors. On average, active managers are underweight in yield-oriented sectors while higher exposures are locked in for passive investors, especially passive value investors.

Receding Tailwinds for Passive

Interest rates are rising, yields on traditional bond investments are climbing, and more normal levels of volatility are returning to the market. We believe these conditions will favor active investors by placing a premium on security selection and risk management.

 

Kevin Toney, CFA
Kevin Toney, CFA
Peter Hardy, CFA
Peter Hardy, CFA
Mike Rode
Mike Rode

Rising Rates and Volatility

July 2018: Investment Viewpoints

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The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

This information is for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. There are different options available for your retirement plan investments. You should consider all options before making a decision. Our representatives can help you evaluate all of your distribution options.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

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