Head of Investment Fund Research
Since the Global Financial Crisis in 2008, active management has seen its share of the investment pie steadily eroded by passive funds and ETFs. In part, this has been due to some poor performance in certain regions and asset classes. Advances in technology giving retail investors easy access to exchange traded alternatives and lower fees charged by passives have also made them the more attractive option for many. However, we may be at another turning point in the debate. With volatility increasing, and the likelihood that we are nearer to the end of the bull market than the beginning, this article looks at why active managers may have the edge going forwards.
Essential to any debate about active vs passive funds is the definition of terms, and an easy first step is to define a passive investing strategy: one that has the objective of delivering gross of fee investment returns similar to that of an index, e.g. the S&P 500 Index or the FTSE 100 Index. Crucially, the size and duration of ownership of underlying securities are determined by the index, and not the provider of the strategy. The market generally considers everything else, more or less, as active.
But in ‘everything else’ lies a big part of the problem. Many so-called ‘active managers’ have given active management a bad name. In particular, the ‘closet trackers’ charging active fees, or active managers with no skill and reliant only on luck. We believe the latter is a cyclical factor with the odds heavily skewed against the investor, while the former is bound to deliver sub-par results due to their inability to outperform net of fees. These are two of the key factors that have contributed to the cynicism around active management.
And it’s taken its toll. Data from the Investment Company Institute (ICI) show that in the US alone index-tracking mutual funds (i.e. passively managed, open-ended funds) and exchange traded funds (ETFs) have gained as much as $2.5trn in the nine years between the beginning of 2008 and the end of 2016. The biggest headwind has been experienced by active US equity mutual funds. Passive US equity mutual funds and index tracking ETFs have gained $2.5trn in the nine years to the end of 2016, while active US equity mutual funds have seen outflows of $1.3tr.
Why do active managers struggle?
There are many reasons why active managers may struggle. Skill is a key factor, and one would expect at least half the market to lag long term, once fees are taken into account. However, certain market environments are not conducive to active management, especially those that rely on bottom-up research to find the best performing companies. Evidence indicates that higher volatility and stock dispersion are both helpful to active managers and enable them to have more chance of outperforming. If stocks in a particular sector are all moving in lock-step and are closely correlated, it’s hard for an active manager to differentiate his or her views on a particular stock within a sector and produce outperformance. This may happen when the market is being driven by a risk-on, risk-off mentality for example, with sectors moving up or down depending on broad market sentiment. Higher volatility also provides opportunities to add to names that may be temporarily out of favour. In the last couple of years in particular, the market has seen lower volatility and stock dispersion.
But what we’ve experienced in the years after the global financial crisis is in many ways not unique. Growth has outperformed value, and momentum has outperformed contrarian approaches. This environment is very much a repeat of the late 90s, when momentum and growth investing outperformed other investment styles for many years. And indeed it was during the dotcom bubble that articles predicting the end of active management started appearing.
Intuitively this makes sense: in growth and momentum driven bull markets, often the big multinationals that caused relatively recent disruption to an industry take the lead as they become cash flow generative and potentially part of a thematic story of the future. Eventually they become big index constituents, and from there, they only become bigger and bigger. The best way to take advantage of this phenomenon is to buy and hold, ride the ‘momentum’ factor, or indeed play the greater fools game and buy stocks that have gone up in the hope that someone else will buy it from you at an even higher price. The best vehicle to take advantage of this market environment is most frequently by investing in the index itself. And hence passive investing gains popularity, and assets.
However the market declines that started in February should be a reminder of when active management is most effective. In general, active managers have tended to perform better in falling markets and markets where value styles outperform growth styles. Poor quality companies are likely to suffer most if a market downturn is caused by a recession (not that we are predicting that today). As Warren Buffett once said, “Only when the tide goes out do you get to discover who’s swimming naked.”
Source: Factset, Quilter Cheviot
From a fund selection viewpoint, we hope to have managers who are able to best discern which companies are most at risk and avoid them, whereas the index by default owns them all. This also provides entry points for opportunistic investors to add to favoured stocks, again not something an index can take advantage of. Outside of mainstream equity, other areas have perhaps even more reason to look towards active alternatives. High yield credit is one such area. Again, the passive fund’s requirement to track the index without regard to quality of issuer may leave the holder open to companies where balance sheets are much weaker, and ability to pay back debt poor in more difficult circumstances. Ultimately, a capitalisation-weighted index in the world of fixed income places a higher weight to a company with more debt, with all else equal. It’s rare that more debt leads to better long-term returns on your investment.
Where does Quilter Cheviot stand on the active vs passive topic?
Regardless of whether we look at historical statistics, or to the fundamentals, we believe the outlook for active management looks as attractive as it has been for a long time. And for three key reasons: