EquitiesThe year of active management

T he recent bear market in equities ranks as one of the most unpleasant on record; the S&P 500’s decline of 38% in 2008 was the worst annual result since the 1930s. The index has also fallen over the past decade, again for the first time since the Great Depression. So what impact has this had on the business of equity investing?

At first glance, one might conclude that little has changed. Stock prices have recovered smartly since the first quarter of 2009, and the S&P 500 has retraced about half of the losses suffered from the peak in the fall of 2007. Market volatility, which hit highs not seen in any living investors’ career (at least in domestic markets), has quickly receded, while the volatility of individual stocks within the market is back to pre-crisis levels. Professional investors, who manage the vast majority of U.S. equity investments, have quickly shifted their preference from the most defensive, least risky stocks back towards much more cyclical choices, taking advantage of the widest spread in valua-tion between cheap and expensive names for a very long time.

But behind this reassuring picture, it is clear that attitudes toward domestic equity investment have been deeply scarred by the last decade. In particular, individual investors have continued to reduce their allocations to domestic equity mutual funds even as the market has recovered. Flows have been heavily directed toward bond funds. In fact, in 2009 investors bought $313 billion worth of bond funds, compared

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2 | Equities: The year of active management

Equities: The year of active management

to a net outflow of $2 billion in equity funds. In addition, equi-ty allocations are being rebalanced in favor of international exposure, especially emerging markets. There appears to be a very strong consensus that returns elsewhere will continue to be better than the returns from U.S. equity, just as they have been over the past ten years. Outflows from large cap funds have been especially noticeable. We have to go back to 2000 to find the last time that individual investors were enthusiastic about opportunities in large cap domestic stocks.

Meanwhile, the trends in institutional investing look very similar. Equity allocations are being reduced, and the proportion of those investments allocated to domestic stocks is continuing to decline. At a recent J.P. Morgan institutional client event, only one investor in a room of over a hundred clients signaled a willingness to allocate more to domestic equity over the next year.

Is this wise? On the one hand, many observers have argued for years that both individual and institutional investors typically allocate more to domestic equity and less to international equi-ty than is theoretically desirable. So from that perspective, the shift overseas would seem to make perfect sense now—and for some time to come. What’s more, an argument could be made that individual investors have probably over-allocated to equity during the good times, and therefore may need a higher fixed income weighting in any case as they grow older. But a skeptic

would point out that both this new found enthusiasm for fixed income, and the persistent appetite for international stocks, may be fuelled in large part by a desire to chase the returns of the past ten years. A typical Core Fixed Income mutual fund, for example, has returned a cumulative 90% after fees over the past decade, while Core Large Cap Equity returns are barely positive. International equity funds have done better, with an average cumulative return of over 16%. Moreover, the current risk premium of equities over both government and corporate debt is very attractive, almost twice the average that we’ve seen over the past 25 years (see Exhibit 1).

The case for domestic equity is a hard one to make in the face of the conventional wisdom that the U.S. economy will under-perform, weighed down by sluggish consumer spend-ing and large government deficits. But, of course, we invest in corporate securities, not economies. And the U.S. corporate sector today looks to be in surprisingly good health when one considers the gloomy economic backdrop. In the third quarter of 2009, large cap companies generated an annualized 8% free cash flow yield, and almost $70 of earnings on an S&P 500 basis. Near term, American companies have again shown an impressive cost discipline and an aggressive focus on main-taining cash flow in a harsh environment. Behind this, the full longer-term benefits of the globalization of the supply chain and the use of technology are still being discovered, with the

exhibit 1: attractive equity risk Premiums vs. treasuries… …and corPorate bonds

Note: The above charts are for illustrative and discussion purposes only. Equity risk premium is equal to J.P. Morgan Asset Management Dividend Discount Rate on S&P 500 stocks, less current yield to maturity on 10-year U.S. Treasury bonds and BAA Corporate bonds. A dividend discount rate (DDR) is the discount rate which equates the pres-ent value of the estimated stream of future dividends to the current market price. The J.P. Morgan S&P 500 DDR is a bottom-up, sector-neutral and capitalization weighted average of dividend discount rates (DDRs) on large-capitalization stocks as estimated by J.P. Morgan Asset Management equity research analysts. A DDR does not represent a stock's expected actual return in any given time period. Source: J.P. Morgan Asset Management. As of December 31, 2009

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worked very well, with the painful exception of 2008. Meanwhile, the most expensive stocks in 1999 were also the largest stocks. Underweighting these has been a consistent source of alpha, again with the brief exception of 2008. And managers that didn’t constrain themselves to the S&P 500 but also chose names from the mid cap world or from inter-national markets found that the odds were very much in their favor as shown by returns that outperformed peers.

So no beta, plenty of alpha. The exact reverse of the ‘90s. Is it a coincidence that the most popular institutional vehicle is now the hedge fund, while in the ‘90s enhanced indexing was the in vogue strategy?

ConclusionLooking forward, I see a return to a more normal relationship between the returns to the market and returns to manager skill. Value spreads have narrowed, large stocks actually look very cheap to us, and the returns from international markets are unlikely to provide quite the same level of boost to a domestic equity portfolio as has been the case for some time. A manager with good insights should still be able to deliver attractive results, but to capture those insights effectively, the more efficient forms of portfolio construction (enhanced indexing and 130/30) are likely to provide a competitive advantage. I would also expect that quantitative managers will be at much less of a disadvantage from here on out. As the period of exceptional volatility passes, many quantitative stock selection tools are likely to prove more effective again. That’s all the more so since “quants” typically have been bigger users of enhanced index and long/short portfolio techniques to make the most of value-added insights.

Given the low expectations, and the remarkable health of the corporate sector, I would expect market returns to reach long-run averages. As that happens, U.S. Equity is likely to slowly regain favor, and provide stiffer competition to other asset classes. Even so, the market is likely to provide a tougher adversary for active managers than has often been the case over the last decade.

effect of reducing capital intensity and improving returns on equity. We see normalized earnings of $95 per share for the S&P 500 two years out, which makes the market look very reasonably valued.

The Wild CardPerhaps the biggest risk to this forecast comes from the difficulty in predicting the policy response to the turmoil in the financial sector over the past three years. It seems highly likely that regulation will impact the profitability of the financial sector, and that taxes will rise for both individuals and corporations to help repair the damage done to the nation’s fiscal position. More broadly, the level of government involvement in many sectors appears to be on the rise, with healthcare the highest profile example of that trend. What this means for profitability isn’t clear, but it is unlikely to be highly positive.

Still, overall we think that investors are overly pessimistic on the outlook for U.S. equities, at least relative to both lower risk assets (bonds) and to other equity markets globally. Strong cash flows and reasonable valuations should support a much better return scenario than has been the case over the past decade.

Although the returns from beta have been slim indeed for many years, there has been one consolation—the returns from active management have been unusually rich. In managing our U.S. Equity business, we assume that if we can beat the market by 2% per year over time, we will achieve top quartile performance. Over the past 20 years, that’s been true; indeed, the 25th percentile manager has beaten the market by 0.6%. Over the past ten years, we find that the level of alpha required to achieve that top quartile goal has been over twice the long-run level. To boast of top quartile returns, an active manager needed to have outperformed the bench-mark by over 4% per year. Even the median manager has been ahead by 2.5% annualized over the past decade.

The collective success of active managers has, in my experi-ence, had a lot to do with the returns to value investing, the performance of large vs. medium-sized and smaller stocks, and the level of opportunities to add value by venturing out-side the benchmark. The last decade has been a near perfect environment because spreads between cheap and expensive stocks had grown extremely wide by the end of the ‘90s, the peak of the Internet bubble. Since then, value investing has

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Equities: The year of active management

This document is intended solely to report on various investment views held by senior leaders at J.P. Morgan Asset Management. The views described herein do not necessarily represent the views held by J.P. Morgan Asset Management or its affiliates. Assumptions or claims made in some cases were based on proprietary research which may or may not have been verified. The research report has been created for educational use only. It should not be relied on to make investment decision. Opinions, estimates, forecasts, and statements of financial market trends are based on past and current market conditions, constitute the judgment of the preparer and are subject to change without notice. The information provided here is believed to have come from reliable sources but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

The value of investments (equity, fixed income, real estate hedge fund, private equity) and the income from them will fluctuate and your investment is not guaranteed. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made.

All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request.

J.P. Morgan Asset Management is the marketing name for the asset management business of J.P. Morgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

© 2010 JPMorgan Chase & Co. | Portfolio 2010

author

Paul QuinseeManaging Director CIO, U.S. Large Cap Core and Value paul.a.quinsee@jpmorgan.com