In the battle of investment approaches, it appears passive investing has been declared the winner—at least, according to the popular press. The virtues of passive management seem to be a favorite topic of white papers, industry conferences and client meetings. It’s no wonder that flows into passive funds and Exchange Traded Funds (ETFs) reached all-time highs in 2016. i To be fair, we think conventional wisdom may have a point: the last seven years have been challenging ones for active managers. But we believe change is in the air—and active management may be poised to regain its performance advantage.
Why We Believe Passive Management Has Dominated for So Long
Typically, active and passive approaches take turns, each outperforming the other for a period of time until the advantage shifts back the other way. Recently, however, passive management has ridden the upper half of the cycle for far longer than many investment professionals would have expected. Several factors may have caused this odd result:
• Central banks around the world have been more active since the global financial crisis, wielding monetary policy measures like quantitative easing, reduced interest rates and other capital controls. These policies stabilized the markets by dampening volatility, but also flattened the typical dispersion in stock returns—creating a challenging environment for stock pickers, which is what active managers essentially are. Now we are seeing central banks stepping back from monetary policy, which may allow for the markets to refocus on company fundamentals
• Investors have been seeking safety and yield, prompted by a drop in government bond yields to record lows, a low-growth global environment, and the ending of a major commodities cycle. This protracted flight to safety drove up the prices of a narrow group of U.S. large cap stocks, the U.S. Dollar, and U.S. long-dated Treasury bonds at the expense of almost every other asset class around the world. However, investor behavior is shifting. Since last summer, we have seen bond yields climb and correlations between stocks declining—conditions that benefit active managers in picking winners from losers
• Investors in general have been increasingly sensitive to fees across all asset classes. Traditionally, passive approaches have offered a significant cost advantage. On a net-of-fee basis, it is difficult for the average mutual fund portfolio manager to outperform the indices in this low-return environment. To put it simply, those active managers with average expertise or portfolios that look similar to the index (“closet indexers”) have often not been worth the cost to investors. ii Recently, however, investors have enjoyed a wider range of lower-fee choices for investing in true active strategies as well—particularly, professionally managed separate accounts iii
Signs That the Times May Be Changing
It is widely known that markets move in cycles. We have seen a prolonged cycle in large cap versus small cap, growth versus value, and passive management versus active management. Conditions are more suitable for active managers to thrive when small cap and value stocks do well, because that means there is more breadth in the market and greater dispersion between stocks.iv
Since the vote in the UK for Brexit and most notably after Donald Trump won the U.S. Presidential election, conditions have emerged that allowed a market recovery to take place and active management to regain its footing. After several years of underperformance, it appears active managers are finally seeing the environment shift in their favor.
Why We Believe a Shifting Environment Could Pose a Threat to Passive Investments
Passive investing may offer many benefits: low costs, easy access to different markets, diversification. But we don’t see it as a silver bullet, and maintain that under certain conditions, it completely falls apart. Right now, with record-breaking flows of assets into passive investments, we are seeing a very crowded trade in the underlying stocks that make up the indexed ETFs. As a result, these stock prices have been driven to levels that are unsupported by company fundamentals.v When the tide turns, the big holdings in these ETFs will falter. ETFs also raise additional concerns about liquidity and pricing, as we saw in August 2015. Sell-offs drove down the market values of underlying stocks to the point that they diverged significantly from the NAV of the ETFs. vi
However, we see the most obvious drawback of passive investing being that when the market does turn, the investor absorbs the full draw-down of the index. And it can be a steep fall: the S&P 500 declined by 52% from peak to trough in 2008 and 2009. vii Active managers aren’t leashed to the indices. They have the opportunity to outperform their respective benchmarks in both up and down markets. What’s more, they tend to focus on risk control as part of their portfolio construction process, gaining an opportunity to avoid risks that are inherent in a broad index and protect on the downside compared to passive approaches.
Positioning Your Portfolio for a New Environment
Investors may want to shift to an active approach—but not any old active strategy will do. Finding skilled managers is key. To assess whether an investment manager is capable of outperforming passive options, look for a consistent and disciplined investment philosophy and process, as well as consistent performance over long periods of time.
It is easy to get caught up in daily headlines and market gyrations. At Anchor, we focus on investing for the long term, seeking quality companies trading at a discount to our calculation of their intrinsic value. While reaping attractive investment results from active management is not a sure thing, our approach to investing has endured over many market cycles.