Is it time for active management to make a comeback?

John Stepek

Active fund managers have been on the back foot in recent years, as the rush of money rushing into passive strategies and ETFs continues to show little sign of slowing. More and more investors are waking up to the idea that investing with active managers means paying high fees in exchange for a very slim chance of consistently beating the market. Why bother, when you can buy a cheap fund that will give you the return on the market (less trading costs)?

Active managers haven't taken this lying down. They've put a lot of effort into attempts to discredit the passive revolution. The arguments range from the theoretical, arguing that there's a tipping point at which passive investment will mean massive misallocation of resources and the undermining of the capitalist system, to the more specific, that passive funds won't be able to protect investors from bear markets (as if active funds will). Apparently, the Investment Adviser Association - a US lobby group - is even setting up a council with the goal of defending active management.

The trouble is, it's hard to make these criticisms of passive stick when so much evidence indicates that active managers really do struggle to beat the market over time. For example, data from Standard & Poor's released earlier this year suggests that nine out of 10 US large cap funds failed to beat their benchmark over a 15-year period.

However, there's an intriguing argument that I've been hearing more and more recently. This is the idea that active management is "cyclical". In effect, sometimes the environment is right for passive to outperform, whereas sometimes active gets the upper hand. And, according to its proponents, we're about to enter one of those times. Indeed, according to Bank of America, in the first half of this year, just over half of all large-cap US equity funds beat the market - a big improvement on the long-term figures (although you still have a barely better than 50/50 chance of picking one that does the business). And in the UK, according to Bernstein Investment Research, the average fund in the UK All Companies sector gained 10.2% in the year to August 8, versus 9% for the FTSE All-Share index.

A momentum business

The argument goes that since the 2009 crisis, markets have shown very little differentiation. Everything has been going up. Correlations have been high (in other words, stocks have been heading higher with little discrimination between them). And the flood of cheap money hitting the market has made the pure momentum trade (buying what goes up, which is what tracking a market cap-weighted index essentially involves) a no-brainer (only with hindsight, of course).

However, with interest rates now starting to perk up, and correlations falling sharply, it's easier for skilled stock-pickers to excel. And depending on where you look, there is some evidence that active vs passive is cyclical. For example, a white paper by investment adviser Hartford Funds suggests that active managers can outperform when "dispersion" - the difference between individual stock performance - is high.

But there are a couple of major problems here. Firstly, as with so many 'passive vs active' arguments, there's the terminology. As is typically the case, the focus is on just one type of passive strategy - tracking a market capitalisation weighted index. This may have been forgivable in the early days of the passive revolution, but these days the passive sector covers such a wide range of strategies and vehicles, that it seems far too glib and simplistic to identify passive purely with one type of investment.

A similar problem exists with sweeping all 'active' funds into one basket. The reality is that a lot of the outperformance comes from specific types of active funds - usually those that are more focused on small caps than their index-tracking peers.

Research from giant asset manager Vanguard has shown that active equity funds (in the UK at least) tend to do better when small-caps are outperforming large caps. In a 2016 piece for fund researchers Morningstar, Vanguard's Todd Schlanger notes that "the success of UK active equity funds is highly influenced by the relative performance of small versus large-cap equities". There's a good reason for that - a market-cap weighted fund will of course favour the larger companies in the index, whereas an active fund will typically have larger weightings towards smaller, faster-growing companies.

And this highlights the real problem with this cyclical argument: it's not so much about active vs passive, as about value or small-cap vs momentum strategies. And that in turn raises the age-old problem of market timing - there are certainly period in which some strategies will outperform others, but who's to say that you'll be able to predict the turn? Most people can't, which is one major reason to own passive market trackers and rebalance regularly, rather than try to shift from one strategy to another at the precisely right moment.

In short, there's a place for both passive and active funds in your portfolio. But the idea that there's a specific environment in which you should dump one for the other is just another red herring being put out by an increasingly beleaguered-feeling active fund industry.

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