Three investments that could return to favor in 2014

Jeffrey Knight, CFA, Global Head of Investment Solutions and Asset Allocation | December 16, 2013

  • When an out of favor investment is re-discovered, sustained outperformance often follows
  • The three criteria we look for in identifying an out of favor asset class or investment strategy
  • Why Japanese stocks, EM stocks and active equity strategies may soon be rediscovered

When investors lose confidence in an asset class, especially one that had been popular enough to attract outsized allocations, subsequent rebalancing generally leads to prolonged periods of underperformance. Technology stocks after 1999, for example, underperformed the S&P 500 in eight of the next 10 years and by a cumulative total of more than 40 percentage points. Today, many believe that interest rate sensitive bonds might have just begun a similar era of waning investor confidence, portfolio reallocation and underperformance. Time will tell.

Importantly, this dynamic works in the other direction as well. When an out of favor asset class or investment strategy is re-discovered by investors, sustained outperformance often follows as fresh investor flows fuel gains. As an asset allocation team, my colleagues and I are constantly on the lookout for such opportunities, where changing beliefs among investors worldwide can drive a reversal of fortune in areas long forsaken. As we near the end of another calendar year, scanning for such opportunities seems appropriate.

To qualify, a potential investment must meet three criteria. First, there must be a well-established pattern of investor outflows over a meaningful period of time. Second, the outflows must be accompanied by genuinely unattractive, yet improving, fundamentals. Finally, we should find some cause for optimism that the underlying fundamentals for the investment might change in a meaningful way to the extent that investors feel compelled to change their minds about allocating capital to such an investment.

On this note, we briefly describe three opportunities that present themselves as candidates — in particular, Japanese stocks, emerging market stocks and active stock selection strategies.

Japanese stocks certainly qualify as a forsaken asset class. After peaking in late 1989, the Japanese stock market has lost 73% of its value over the subsequent 14 years. Following decades of underperformance, most investors have been conditioned to approach this market with skepticism and this skepticism has been validated over and over again. We can hypothesize, safely I believe, that most investors believe Japanese stocks will always disappoint. Japanese stocks meet our first two conditions.

But something must happen to motivate a change in investors’ beliefs to truly activate the investment opportunity. We think 2014 could deliver such a catalyst. With world beating performance in 2013, and a forceful combination of policies commonly known as “Abenomics” to provide a story line, the stage is set, we believe, for a change of heart regarding Japanese equities. Corporate earnings strength could seal the deal, and our bottom up expectations for Japanese corporate earnings growth next year is higher than the levels that we expect in the United States, the UK or Europe. For these reasons, we begin 2014 with an overweight position in Japanese stocks.

Regional twelve month forward earnings year over year growth rate

Source: IBES Global Estimates, Datastream, November 2013.

Emerging market stocks are also tempting. These stocks have essentially sat out the last 18 months of worldwide equity rallies, and in doing so have become among the world’s most attractively valued assets. However, to pass the screen for purposes of this analysis, the asset class must be deeply out of favor and marked by investor skepticism. We do not think that emerging market stocks have reached that point yet.

S and P 500 versus MSCI emerging markets

Source: Columbia Management Investment Advisers, LLC, November 2013.

According to Morningstar, for example, cumulative net flows into Emerging Market funds for 2013 were at $32.9 billion (through 11/30/13). From a psychological standpoint, it is surely feasible that investors are still in the early stages of losing faith in emerging market stocks. They might be worth buying for other reasons, but not because they are about to become a rediscovered investment.

Which brings us to our final candidate, active equity strategies. One of the most pronounced trends in the investment industry over the last 10-plus years has been the replacement of active equity strategies with passive, index-oriented holdings. Flows out of active equity products have been quite negative as many investors have generally come to believe that passive strategies always outperform. Thus, active U.S. equity strategies meet our first two conditions.

Slowing outflows from active funds track the recovery of active fund alpha

Source: Instinet, November 25, 2013 “Will active managers succeed? Forecasting when active beats passive” – Joseph J. Mezrich.

We think fundamentals could shift in favor of active strategies in the year ahead and thus give us our third corroborating piece of evidence which may foreshadow a period of outperformance ahead. In a recent research paper published by Instinet, the author, Joe Mezrich, points out that not only have active funds been outperforming over the last eight months of 2013, but conditions in the stock market are consistent with a continuation of this outperformance. Additionally, active returns could very well represent a larger proportion of equity strategy returns in the year ahead should the torrid pace of market gains decelerate, as many expect. If active equity strategies can continue to deliver excess returns versus passive strategies to the degree that relative flows between the two reverse, then we believe the cycle of strong active performance could enjoy an additional tailwind from investor flows.