In the most recent bull market, passive investments outperformed actively managed funds, leading many to question whether the added costs of active management are worth it. Inflows into passive investments led to a milestone event in September 2019 in which the assets of U.S. index-based equity mutual funds and ETFs surpassed actively managed funds for the first time. Even active investing icons Warren Buffet and Peter Lynch recently conceded that passive management would likely become the way of the future.
But a look at the last 35 years shows that active and passive investing are cyclical, trading places in terms of their outperformance over large periods of time. As one fund manager observes, “Just when it seems that active or passive has permanently pulled ahead, markets change, performance trends reverse and the futility inherent in declaring a ‘winner’ in active vs. passive is revealed anew.” The magnitude of disruption we’ve seen in the wake of COVID-19 may well have set the stage for a shift in the cycle.
3 Factors Favoring Passive Investing Are Now in Flux
In the past, three sets of characteristics have given passive investments an advantage:
1. Low Stock Dispersion
When the dispersion of stock returns is low, fewer companies pull ahead of the pack. Lower dispersion levels can be common in markets like we’ve just experienced in which “a rising tide lifts all boats.” Today, the tide has gone out and dispersion levels are rising, giving active managers with strong stock-picking skills more opportunity to generate alpha.
2. High Stock Correlations within Equity Style Boxes
Over the last 11 years, large cap equities have experienced above normal correlations, with share prices moving more on macroeconomic news about central bank action and trade negotiations than on changes in company fundamentals. In the aftermath of COVID-19, the health of individual companies will likely matter more, playing to the strengths of active managers.