New Research Confirms Active Funds' Place In Your Portfolio

by: Institute for Innovation Development
Summary

New research about the active-passive debate is revealing many interesting and contradictory results that challenge conventional wisdom and current industry practices .

A research study concludes active funds outperform based on relative 20-year performance time frames and are more consistent and less volatile than passive funds.

Advisors should continue to think critically about their research and assumptions on the active-passive debate, especially the role of risk control that active funds can offer during changing market conditions.

[The negative, relative performance perceptions of active funds versus passive funds are beginning to calcify and become ingrained into our collective unconscious, approaching urban legend or myth status. However, those conclusions would be misleading.

From my view, the ongoing industry debate has always been a matter of the perspective and chosen data set and time frame one wishes to focus on. My point is that it’s healthy to regularly challenge your assumptions and perspectives and not rely solely on current trends in conventional investment wisdom.

While some of the original research and facts used to tip the scales towards passive investing are valid, there are studies coming out isolating more expansive data sets, offering different perspectives, and creating new approaches to researching this debate. Newer research and subsequent insights are revealing many interesting and contradictory results that challenge conventional wisdom and current industry practices that advisors should be aware of.

One such study is from Institute member Sean Brown, President and CEO of YCharts, an investment research platform for wealth advisors and institutional investors. We sat down to discuss his recent research report, “Can Active Management Still Add Alpha?”]

Hortz: What was your motivation for doing this research? Why should wealth advisors be reassessing active management?

Brown:With equities’ historic bull run since the 2008 financial crisis, investor sentiment has favored passive strategies, like index-tracking ETFs, and actively managed mutual funds have seen major outflows. We wanted to test active funds across years, asset classes, and various performance and risk metrics to answer these questions: can active management still provide alpha? And if so, are there any patterns as to when it is more likely to do so?

Wealth advisors should reassess, or at least be knowledgeable about, the benefits that active management can provide their clients. While passive management performs well during market tranquility, active management may offer superior risk controls. Many long-tenured fund managers have also outperformed their benchmarks over the last 20 years. Proactively identifying these managers may be a challenge, but data shows it could be worthwhile.

Hortz: You determined that you were going to go about doing this research differently. How did you fashion your research methodology to have a different approach?

Brown:Instead of using category averages or combined results of every active fund, we looked at some of the largest, most established funds across several major asset classes. Taking each asset class's top 25 funds by AUM with a track record at least back to the year 2000 and manager tenure longer than the last bear market, we averaged the returns each year to establish an "average active" return series. This approach provided what we determined to be an interesting way to evaluate "active" managers, in that it includes the most invested-in funds and gives equal weight to the best and worst funds in the sample each year.

Hortz: What were the key results from your research on active versus passive funds? Why should wealth advisors be paying attention?

Brown:Our key results include the following:

  1. On the basis of returns, selecting the correct asset class tilt is approximately 10X as important as deciding whether to invest in active vs. passive funds
  2. Over the last 20 calendar years, the annual returns for Active Funds studied outperformed their respective passive benchmarks 57% of the time, across all asset classes
  3. More than ⅔ of the time, actively managed equity funds are more consistent and less volatile than their counterpart passive funds
  4. Selecting the “right” actively managed equity fund can lead to 10-30x greater returns, in relation to passive investing.

Essentially, advisors should have an approach that first captures the best asset mix for their client but also be aware of how different securities in that asset class could impact risk and returns. Dismissing all active strategies could negatively impact clients’ returns, and it’s the advisor’s responsibility to be educated on all available options.

Hortz: What else did your research uncover on ways that active funds added value beyond return metrics?

Brown:Unsurprisingly, we found that active funds added value with regard to lower drawdown and less volatility. Since passive funds cannot, by definition, stray from an index’s allocation, they’re less able to protect investors from downside risk when markets sell off. Active managers, however, are able to shift allocations when faced with headwinds, either proactively or reactively.

In our research, the pool of active funds had superior risk-adjusted returns in anywhere from 53-79% of years, as compared to passive funds. We also tested both strategies for standard deviation of returns and maximum 30-day drawdowns. This showed that active funds in all asset classes studied, with the exception of fixed income, delivered better downside protection than their passive counterparts.

Hortz: What was the single most surprising fact you uncovered?

Brown:We ran a quick test to gauge how badly an investment manager would perform by "chasing returns" and investing each year in the active fund that had performed the best the year prior. Surprisingly, this strategy outperformed simply staying in the passive investment for the whole period. We still don't recommend this strategy, but it made a good point about experienced active managers’ ability to keep a winning streak going.

Hortz: What does this say to you about the need to keep doing quality research and continuously challenging conventional wisdom and assumptions?

Brown: It’s a long-held belief that a contrarian approach leads to alpha and beats the market. While active management isn’t necessarily a “contrarian” strategy, it certainly feels that way of late, with so many investors opting for index funds.

It’s important to continuously conduct research, test new strategies, and challenge your own biases because, as our study shows, market conditions change often, and sometimes quickly. A “buy and hold” strategy can serve an investor well, but tactical shifts that preserve capital are even better.

Hortz: What are your recommendations to advisors on how they should think about and respond to this research?

Brown: Our recommendation is that advisors continue to think critically about their research process and how that process adds value to their clients. Our research and conclusions show that, while passive investing has been able to deliver meaningful performance, active investing still has a place in investors’ portfolios.

It’s an advisor’s duty to stay informed on all of the investing options that are available to a client and keep an open mind. Being aware of changing tides, and which asset classes or strategies are poised to outperform, can help advisors deliver more value to their clients.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I wrote this article myself and I am not receiving compensation to write this article but I do have a business relationship with YCharts who is an Institute member. The Institute is a business innovation platform of over 100 innovative firms that are openly sharing their unique perspectives and activities to build awareness and stimulate new approaches/thinking for a financial services operating environment of accelerating change.