Over the past few years the investment management paradigm has shifted. An increasing number of retail investors have incorporated passively managed investments in their portfolios. Investment management firms have responded by adding new and exotic passive investments to their product lineups.
The below EPFR Global graph illustrates this shift in investor sentiment. Since 2014, U.S. passive equity funds have brought in over $600 billion in assets while U.S. active equity funds have seen the exact opposite happen: outflows of nearly $800 billion.
Below, we take a closer look at the active vs passive investment argument, which asset classes provide opportunities for financial advisors to find alpha, risks with passive investments, and will this trend continue in 2017 and beyond.
Followers of the Random Walk theory have argued that markets are efficient and that consistent manager outperformance has more to do with luck than skill, which has led many to passive investments. A renewed emphasis has been placed on investment management fees, which has caused a price war, benefiting passive investments. Investors are also attracted to passive investments due to their increase in tax efficiencies compared to active investments.
However, there is more to the story that financial advisors must consider when comparing active investments to passive investments.
The popularity of passive investments has taken off since the bottom of the credit crisis, as figure 2 shows; it’s easy to see why. When looking at a universe of all U.S. equity mutual funds, the Russell 3000 index ranks in the top half and in some cases the top quartile.
When one peels away the layers and looks at the individual asset classes, one can find opportunities for active management. For starters, small caps and European stocks tend to provide investors opportunities to add alpha to their portfolios. Until recently, the Russell 2000 Value index has ranked in the bottom half of all small-cap value mutual funds since the beginning of 2009 (figure 3).
Investing overseas provides additional opportunities for active investors, for example, diversified emerging markets. Figure 4 shows that the return rank for the MSCI Emerging Market index is very inconsistent, which provides active managers the opportunity to outperform more consistently.