From the November 2016 issue of Investment Advisor • Subscribe!

Actively Going Passive, but at What Cost?

Reminder: Mean reversion can be mean, and it's a powerful force in markets

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The artificial environment created by central bankers around the globe has lead to frustration. The artificial environment created by central bankers around the globe has lead to frustration.

Over the past few weeks, as we’ve traveled around the country visiting with advisors, a few common themes have arisen. First, we’ve seen great frustration associated with trying to make sense of the artificial environment that has been created by central bankers around the globe. Second, we’ve seen a similar level of exasperation over the inability of active managers to make sense of the artificial environment that has been created by central bankers around the globe — hmm.

According to Morningstar, as of Sept. 30, actively managed mutual funds experienced outflows of approximately $304 billion over the trailing 12-month period, while passively managed funds and ETFs brought in $437 billion. That is quite a shift.

Indeed, it has been a tough stretch for active management. Data from S&P Indices Versus Active (SPIVA) reports indicates that through June of this year, 81% of domestic large-cap equity funds, 84% of mid-cap funds and 94% of small-cap funds underperformed their respective benchmarks over the past three years.

While active management is always a difficult proposition (and alpha generation as opposed to straight outperformance is always a zero-sum game even before fees), the playing field shifts over time, with certain environments being more conducive than others for skilled practitioners.

The SPIVA mid-year report in 2011 showed that 64% of large-cap, 75% of mid-cap and 63% of small-cap funds underperformed their benchmarks. Still large percentages to be sure, but the differential in those metrics five years ago versus where we sit today is eye opening.

So what does a positive environment for active management look like? Our observations and numerous studies have generally indicated that active approaches tend to perform better when:

  • Smaller capitalization companies are outperforming (active portfolios tend to have lower average market caps than passive indexes, in part because equal weighting rather than market-cap weighting is the preferred portfolio construction approach).

  • International companies are outperforming U.S. companies (most domestic equity portfolios have some exposure outside of U.S. markets for a variety of reasons).

  • Value stocks are outperforming growth stocks (active managers tend to focus on valuation).

  • Overall stock market returns are more subdued (active managers almost always have a cash drag they have to battle).

  • Correlations between stocks are lower (meaning there are more stock specific factors driving returns).

Comparing Active and Passive Management

With that in mind, how do these three-year periods compare on those measures? The table above shows that on every measure, the three-year period ending in June 2011 was much more favorable to active management than over the three-year period ending in June of this year. To be fair, this simple comparison is not the same as a statistically rigorous study, but the results do echo what we’ve seen, as well as what we’ve experienced while managing money over time.

So at what expense are investors throwing in the towel on active management? I guess it depends on one's outlook. Is it likely that the largest names will continue to outperform? Is it likely that U.S. equities will dominate over the coming years? Is it likely that value stocks will remain the underappreciated little brother of growth stocks? Is it likely that equity markets will put up large returns in the coming years? Is it likely that stocks will continue to move as a herd, rather than based on individual fundamentals?

Mean reversion can be mean, and it's a powerful force in markets. We’d hazard a guess that the tide will soon turn on many of these trends, and with it, investors will inevitably question why they gave up on active management. When everyone is doing the same thing, the payoff diminishes. We’d suggest that you think about how you’d like the conversation with your client to go three years from now, and plan accordingly.

--- Read ‘Pundits’ See More ETF Growth; Reduced Active Management on ThinkAdvisor.

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