When you apply for health insurance, do you look for the cheapest plan you can find? When you get sick, do you look for the cheapest doctor? If you are unfortunately accused of a crime and require legal assistance, do you look for the cheapest attorney? Most people would resoundingly answer no. With something as important as your financial situation and investing, does it makes sense to find cheapest solution? According to John Bogle, founder of the infamous Vanguard group, "On average, it's a simple fact that passive indexing always has and always will outperform active fund management--it's as certain as night follows day in this uncertain business." Couple that with extremely low costs and it would seem that investors should go passive and avoid the high fees and underperformance risk of active investment strategies.
Unfortunately, as disclosed on Vanguard's prospectus, "Past performance is no guarantee of future results." In fact, history shows that passive and active investing strategies performance moves in cycles. Going back to 1985, active strategies have outperformed passive strategies 50% of the time and I believe we are on the cusp of the next phase in the cycle where active managers outperform low cost passive strategies like (NYSEARCA:SPY) and (NYSEARCA:VOO).
One of the main valuation metrics that strategists and analysts utilize to forecast long term returns is Robert Shiller's cyclically adjusted price-earnings ratio, or CAPE ratio. When the CAPE ratio is high relative to long term averages, future return expectations decrease. When the ratio is low, long term return expectations increase. Currently, the CAPE ratio is idling at 28 times earnings, extremely high relative to the long term average of 16. The last time the CAPE ratio traded above these levels was in late 1920s and the late 1990s, and both preceded market crashes. Unfortunately, passive investment strategies provide no protection in the event of a downturn. Passive strategies by design will experience the same volatility and drawdown of the index they track.
On the other hand, active strategies can provide downside protection. For example, if you put a million dollars at the end of 1999 in S&P 500 index funds, you would have generated a negative 44% return and an ending portfolio value of about $560,000. The same strategy invested in active strategies would be down about 29% with an ending portfolio value of $710,000. As a result, it may be a good time to reduce your exposure to passive investment strategies. Consider an active strategy with a value tilt and high active share. These types of strategies can provide downside protection and alpha if markets continue their upward trajectory.
If you turn on the television, browse the web, or listen to radio, you will be inundated with advertisements suggesting active management is dead and too expensive. The advertisements will substantiate their claims pointing to passive expense ratios being 95% less expensive in some cases. From the performance side, they will highlight the last six years where passive managers outperformed active managers. What they leave out, is over the last 30 years, active managers have outperformed passive managers 50% of the time.
The studies also measure the universe of active managers and are not measuring individual active managers' outperformance or volatility mitigation. Many active managers have much higher batting averages against passive and meaningful outperformance over their respective benchmarks. For example, JPMorgan US Large Cap Core Plus Fund (MUTF:JLPSX) has outperformed the S&P 500 index over 170 basis points annually over the last ten years despite passive's epic run. Always remember, expenses are only an issue in the absence of value.
As a result of fee compression and underperformance of active strategies, passive fund flows are hitting all time highs. According to Morningstar, in September 2016, passive fund flows eclipsed $450 billion while active funds hemorrhaged almost $300 billion in assets. This trend may continue due to the recent passing of the Department of Labor Fiduciary Rule. The Fiduciary Rule will put further pressure on active managers to justify their fees. Despite passive flows hitting all time highs, actively managed funds still make up about 60% of the total asset pool in the United States. The flood of assets into passive strategies has created high equity correlations and enables talented and nimble active managers to outperform. The lead portfolio manager and CEO of Ariel investments, John Rogers, seems to agree. According to John, "Everybody has been buying the same stocks and enjoying the returns of the index fund." He argues, "The next ten years will be great for stock pickers." Ariel Investments is an active manager overseeing over $10 billion dollars in assets under management.
With valuations near the highest level we have seen in the last 100 years, investors should consider active strategies that can provide lower volatility and downside protection if markets sell off. While active managers are still being hit with massive outflows due to underperformance and expenses, current valuations are creating a perfect environment for active managers and stock pickers to outperform. Frequently, "The darkest hour is just before the dawn."
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.