By Brian Levitt, Senior Investment Strategist
I never believed in the prevailing view that active management is dead.
I know, I know: As Upton Sinclair said, "It is difficult to get [someone] to understand something when [that person's] salary depends on not understanding it." Fair enough.
But it's not that I was willfully ignorant, waiting around for the final nail to be hammered into the coffin of active management. It's just the opposite, actually. I work for a global asset manager that has diversified into a wide range of investment strategies, including rules-based strategies with different weighting methodologies than market capitalization. Many of our firm's assets are in global, international, and emerging-market equities - as well as in investment-grade, international, and emerging-market fixed income - where active managers have consistently outperformed their benchmarks over most intermediate- and long-term periods (Exhibit 1). We also have highly competitive products in categories in which active winners are less prevalent. So, I do have a dog in this fight - but perhaps not as big as it may seem at first glance.
Rather, my own professional history has led me to believe that even in U.S. markets, these matters are cyclical. In 1998, when I entered the asset-management industry, active managers - particularly those who "understood" the new technology-driven economy - were treated like rock stars, until they weren't. Within a few years' time, hedge fund managers who provided downside protection during the 2000-2001 "tech wreck" were all the rage, until they weren't. In the post-financial-crisis world of easy money, virtually zero interest rates, and limited economic and monetary-policy volatility, passive strategies have been ruling the day.
Am I now supposed to believe that investors have gone in 15 years from paying a "2-and-20" fee structure to hedge funds, practically begging for access, to now and forever only willing to pay three basis points for market-capitalization-weighted strategies? Or is it more likely that investors have become complacent, given that it's been 18 years since valuations on market-capitalization-weighted strategies significantly overshot and reverted all the way back to their means and lower? I'd argue that it's the latter.
Sinclair also said that "It is foolish to be convinced without evidence, but it is equally foolish to refuse to be convinced by real evidence." What's the evidence that passive's run may be a cyclical phenomenon rather than a structural shift in market leadership? Consider the following:
- From 2001-2009, a period marked by two recessions, the rolling monthly 5-year return of the S&P 500 Index ranked, on average, in the 49th percentile of the Morningstar Large Blend Category.1
- From 2010-2015, a period marked by easy money and zero interest rates, the rank of the rolling monthly 5-year return of the S&P 500 Index steadily climbed into the top decile. Asset flows into index strategies followed.2
- Since the U.S. Federal Reserve (Fed) raised rates in December 2015, the S&P 500 Index has ranked in the 38th percentile of the Morningstar Large Blend category. For the year ended December 31, 2017, a year in which the Fed raised rates three times, the S&P 500 Index ranked in the 44th percentile of the category.3
To me, this evidence epitomizes the cyclical nature of these things but time will ultimately tell. For now, there is enough long-term history on the ETF strategies tracking the Morningstar style-box indices to render a reasonable verdict.
Consider that the performance of the most widely held ETF strategy tracking the S&P 500 Index since its inception (May 15, 2000) ranks in the 45th percentile. The most widely held ETF strategies tracking the Russell 1000 Value Index and the Russell 1000 Growth Index since their inceptions (May 22, 2000) rank in the 56th percentile and 69th percentile of the Morningstar Large Cap Value and Morningstar Large Cap Growth categories, respectively. The small-cap ETFs tracking the Russell 2000 indices look significantly worse. These returns are middling or worse (Exhibit 2). To be fair, I'll confess that it is the mid-cap value and mid-cap blend managers who seem to be facing the stiffest competition from passive market-cap-weighted strategies.
I know that one blog isn't necessarily going to change people's behavior. But I worry when I see cumulative asset flows of $1.1 trillion into passive market-cap strategies and $885 billion out of actively managed strategies.
As General Patton said, "If everybody is thinking alike, then somebody isn't thinking." An entire generation of investors hasn't lived through a Fed rate-tightening cycle or a period when overvalued markets undergo a correction (remember, markets were not overvalued in 2008). Others simply don't remember. As the Fed's tightening cycle progresses and valuations become increasingly elevated, it feels like the shift toward the outperformance of active-management strategies or alternatives to market-capitalization-weighting methodologies is already happening. My salary may partially depend on it, but that doesn't mean that I am necessarily wrong.
- Source: Morningstar Direct, as of 12/31/17.
- Source: Morningstar Direct, as of 12/31/17.
- Sources: Bloomberg and Morningstar Direct, as of 12/31/17.
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