Is it Time to Act(ive)?

Total intra-market correlations within the Russell 1000 have fallen from post-crisis highs reached in 2015. As the chart below shows, correlations are now near 15-year lows, suggesting an improved environment for stock-pickers. We find this intriguing, especially in light of the money flowing out of active and into passive strategies, as high correlations have been a factor in active money managers’ challenges in beating the market.

Russell 1000 Index. Source: 361 Capital

A valuable skill in investing is the ability to spot a trend (or reversal thereof) before the masses, and to capitalize on the subsequent shift in beliefs. From a value investor’s perspective, they would say finding strong prospects among unloved and forgotten assets when money is chasing other things is part of their success. This is apropos to managers as well.

Are we at a point where fund flows will stabilize or reverse?

Recent Morningstar data tells us that passive equity funds are still gaining at the expense of active. However, the spread between net inflows into passive from active has narrowed. We are not predicting the trend will completely reverse in the near future as we cannot accurately predict that (nor would we even attempt to). But, the fact that market watchers are raising questions about structural changes relating to liquidity, ownership concentration, and marketing-driven products, definitely makes us wonder how long this will last. (See Barron’s recent cover story, which sheds light on the structural changes afoot due to the rise of passive investing, as well as our previous post).

Source: Morningstar (as of June 20, 2017), 361 Capital

There is good reason to employ passive strategies as part of an investment plan. However, if the basis for shifting to passive is solely because of following the money, then that is a reason to be cautious and think about it from a behavioral standpoint. Behavioral finance tells us that herding tends to occur because we feel comfortable in the crowd. With so much money moving in one direction, it makes it mentally easier for the next investor to justify the same decision. Along the same line, there is social proof in doing what is popular.

  • “Social proof, sometimes roughly termed the “herd instinct”, dictates that individuals feel they are behaving correctly when they act the same as other people. In other words, the more people who follow a certain idea, the better (truer) we deem the idea to be. And the more people who display a certain behavior, the more appropriate this behavior is judged by others.” 

There is no arguing the fact that passive has fared well relative to active since the financial crises. As any standard disclaimer will tell you though, past performance does not guarantee future results. And if the structure of the market is changing, should we expect similar relative performance going forward? Considering the pace and direction of fund flows over the past few years, coupled with the fact that stock correlations are near 15-year lows, it could be prudent to think about differentiated equity strategies and beware of the “crowded trade”.