Actively Going Passive, But at What Expense?


Over the past few weeks, as we’ve traveled around the country visiting with advisors, a few common themes have arisen. First, great frustration associated with trying to make sense of the artificial environment that has been created by central bankers around the globe. And second, a similar level of exasperation over the inability of active managers to make sense of the artificial environment that has been created by central bankers around the globe…hmm.

Anyway, investors are clearly voting with their dollars. According to Morningstar, as of September 30th, actively managed mutual funds experienced outflows of approximately $304 billion over the trailing twelve-month period, while passively managed funds and ETFs brought in $437 billion.

That is quite a shift. Indeed it has been a tough stretch for active management. Data from S&P’s SPIVA reports (i.e., S&P Indices vs. Active) indicates that through June of this year, 81% of domestic large cap equity funds, 84% of mid cap funds, and 94% of small cap funds underperformed their respective benchmarks over the past three years. Ouch.

But while active management is always a difficult proposition, and alpha generation as opposed to straight outperformance, is always a zero-sum game even before fees, the playing field shifts over time, with certain environments being more conducive than others for skilled practitioners. The very same SPIVA mid-year report in 2011 showed that 64% of large cap, 75% of mid cap and 63% of small cap funds underperformed their benchmarks. Still large percentages to be sure, but the differential in those metrics five years prior versus where we sit today is eye opening. The landscape was clearly much kinder over that three-year period.

So what does a positive environment for active management look like? Both our observations and numerous studies that we’ve seen over time have generally indicated that active approaches tend to perform better when:

    • Smaller capitalization companies are outperforming (active portfolios tend to have lower average market caps than passive indices, in part because equal weighting rather than market cap weighting is the preferred portfolio construction approach)


    • International companies are outperforming U.S. companies (most domestic equity portfolios
      have some exposure outside of U.S. markets for a variety of reasons)


    • Value stocks are outperforming growth stocks (active managers tend to focus on valuation)


    • Overall stock market returns are more subdued (active managers almost always have a cash
      drag that they have to battle against)


    • Correlations between stocks are lower (meaning there are more stock specific factors driving returns)

With that in mind, how do these three-year periods compare on those measures?

Comparison of Three-Year Periods For Active Management chart

On every measure, the three year period ending in June 2011 was much more favorable to active management than over the three year period ending in June of this year. Now to be fair, this simple comparison is not the same as a statistically rigorous study, but the results do echo what we’ve seen, as well as what we’ve experienced while managing money over time.

So at what expense are investors throwing in the towel on active management? I guess it depends on one’s outlook. Is it likely that the largest names will continue to outperform? Is it likely that U.S. equities will dominate over the coming years? Is it likely that value stocks will remain the underappreciated little brother of growth stocks? Is it likely that equity markets will put up large returns in the coming years? Is it likely that stocks will continue to move as a herd, rather than based on individual fundamentals?

Mean reversion can be mean, and it’s a powerful force in markets. We’d hazard a guess that the tide will soon turn on many of these trends, and with it, investors will inevitably question why they gave up on active management. When everyone is doing the same thing, the payoff to that approach undoubtedly diminishes. We’d suggest that you think about how you’d like the conversation with your client to go three years from now, and plan accordingly.