Radioactive: Is Passive’s Dominance Over Active Set to Wane?

Key Points

  • Monetary policy, growth and inflation conspired to elevate correlations and passive’s outperformance over active
  • But the winds are shifting and regimes are changing; supporting a better environment for active management
  • A balance between the two strategies will likely serve investors best

One of the key themes I and my strategy colleagues highlighted in our 2017 outlook was the regime change from monetary policy being the only game in town to fiscal policy taking at least one of the reins.  There are important implications of this shift—key among them is likely a shift from passive (index-oriented) investing strategies being rewarded with both strong performance and flows, to more active strategies garnering more flows and generating better returns.  The latter have struggled throughout the current bull market.  The usual inefficiencies seen in market pricing waned, making it more difficult for actively-managed funds to find an edge and outperform. 

Passive has dominated active

In the double chart from Ned Davis Research (NDR) below you can see these trends. The top field shows the outperformance by the publicly-traded stocks of passive ETF managers relative to those of active mutual fund managers. The bottom field shows the significantly stronger in growth in passive assets relative to active assets.

AUM Growth and Stock Performance

 

Three performance cases in point

First, hedge funds—dominant in active strategies—have underperformed the S&P 500 every year since 2008, according to Strategas Research Partners. It's the longest stretch of underperformance in the history of hedge funds.  Second, in the seven full years during this bull market—2010 through 2016—only one-third of U.S. large-cap growth active managers outperformed the Russell 1000 Growth Index, according to Morningstar data. Third, across large-cap growth, large-cap value and large-cap blend, less than 20% of active managers have outperformed their benchmarks over the latest three-year rolling period.

Low volatility/growth/rates supported passive

In addition, volatility has been exceptionally subdued, which has also been to the benefit of passive over active.  Perhaps not imminently, but we do believe volatility is likely to rise, which would be to the benefit of active over passive.  Also subdued has been economic and earnings growth, which makes it more difficult to differentiate the stock market’s winners from the losers.  Today though, tighter monetary policy is reflecting a stronger growth outlook, while earnings growth is surging from its four-quarter "recession," which ended in the third quarter of 2016.

The Z/NIRP (zero/negative interest rate policy) era was defined by "risk-on, risk-off" trading, causing correlations within and among asset classes to shoot higher; and investors to question the merits of diversification.  The chart below shows the dramatic plunge in the S&P 500's 65-day rolling correlation.  This means that the stocks within the index are no longer acting similarly—a lower correlation means a higher dispersion among returns.

S&P 500 rolling 65-dy correlation

Source: Strategas Research Partners, as of February 24, 2017.

The same can be said for correlations among global equities.  Again, a lower correlation means a higher dispersion among returns of global equity asset classes.  It’s making the argument against diversification more difficult to make.

Global equities 52-week correlation

Source: Strategas Research Partners, as of February 24, 2017. Rolling 52-week correlation among: S&P 500, Germany DAX, France CAC, UK FTSE 100, Spain IBEX, Swiss SMI, & Japan Nikkei.

The aforementioned environment caused an epic shift of investor assets from active, like traditional actively-managed mutual funds; to passive, like exchange-traded funds (ETFs).  As you can see in the chart below, traditional domestic mutual funds have been bleeding assets nearly every year since before the financial crisis; while ETFs have picked off many of those flows.

Net new cash flow

Source: Investment Company Institute (ICI), as of December 31, 2016. Chart plots domestic equity fund flows.

My friend and founder of Strategas, Jason DeSena Trennert, had this to say in a recent report on the subject of active vs. passive:  "The good news for active managers, is that we are entering a sweet spot in which real rates are still low and stimulative but in which inflation is rising fast enough for the markets to ration debt capital.  While this may lead to lower aggregate Index returns at precisely the time so many investors have become so enamored with passive investment strategies, it will also likely lead to a divergence of fortunes among companies that should allow stock pickers to once again have their day in the sun."

Caveats and the bottom line

Although we do believe the macro winds are shifting more in favor of active strategies, there are several important caveats.  Most importantly, at Schwab we believe in both.  In fact, our studies have shown that an allocation which blends both passive and active strategies has generally outperformed strategies that solely focus on one or the other.  In addition, the fees investors pay for these vehicles will continue to be a factor.  According to NDR and the Financial Times, the average expense ratio of U.S. equity funds dropped from 99 cents for every $100 invested in 2010 to 68 cents in 2015; however passive funds remain cheaper.  What I’m suggesting is that the trajectory of passive’s dominance over active is unlikely to persist without some reversion to the mean.

 

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