With tech giants on shaky legs and several banks forecasting a recession by the end of next year, the moment may soon come where active ETFs reverse years of underperformance – or we could just be seeing another blip of alpha.

We are often regaled by stories of active managers outperforming during periods of volatility and history also proves this point to an extent.

In more than two decades of S&P Dow Jones Indices’ SPIVA data, large-cap managers have only beaten the S&P 500 in three years, the most recent being the Global Financial Crisis (GFC) aftermath of 2009.

Active managers have also started 2022 off on the right footing. In fact, the majority of US active equity funds beat their relevant benchmarks in the first four months of the year while the S&P 500 returned -13.9%.

Jeffrey Ptak, chief ratings officer for Morningstar, said: “Around 60% of such funds posted higher returns than their style-specific benchmark so far this year, as at 30 April. Why? They did well during the two drawdown periods (1 January-14 March and 30 March-30 April), as shown.”

These findings are consistent with an earlier correction by US indices in 2018. Over this short period between January and February, Morningstar data showed 57.4% of actively managed funds beat their benchmarks.

On this, Ptak said: “Nearly 60% of active US equity funds outperformed their bogy in down periods, on average.

“By contrast, only approximately 32% of active US stock funds beat their indices in up periods, on average, meaning the odds of succeeding were almost twice as good when the market was down than when it was up.”

Unfortunately, the extent and duration of active outperformance during market unrest is limited, as illustrated by European Securities and Markets Authority (ESMA) research into peak pandemic volatility during H1 2020.

ESMA said: “More than half of the active UCITS analysed underperformed their benchmarks during the stressed period (between 19 February and 31 March) and more than 40% during the post-stress period (between 1 April and 30 June).”

While European active managers outperformed their benchmarks by up to a percent during the stabilisation period, they underperformed by an average of 0.9% during peak market stress in the final week of March 2020.

“The finding of no sustained outperformance for active funds, throughout H1 2020, is in line with the outcome of recent analyses and financial news focusing on the unfolding of the COVID-19 crisis,” ESMA continued.

“The Morningstar Active/Passive Barometer shows that only around half of active equity funds outperformed compared to their average passive peer in H1 2020.”

Fun but unpredictable and brief

Unfortunately, while the active alpha in choppy waters thesis holds some truth, outperformance is largely short-lived at best.

In fact, Morningstar’s Ptak said of the active funds that outperform during 36-month market “down” periods, just a third continue to outperform over the subsequent three years.

Finding the winning ticket is also no guarantee for an investor. Not only do they have to find the right manager to make active worthwhile but SPIVA Europe data shows funds in different domiciles have radically different outcomes.

In 2020, 34% of French-domiciled active equity funds underperformed their relevant benchmark versus 55% and 61% in Italy and Spain, respectively.

Even after enjoying some success during the height of COVID-19 disruption, the percentage of Europe equity funds outperformed by their benchmark increased by 37.4% between 2020 and 2021.

“From this we can surmise that, on average, fund managers in this region may have utilised their skills better during more volatile market conditions than in a comparatively stable environment,” Andrew Innes, head of global research and design, EMEA at SPDJI, argued.

“However, as SPIVA frequently witnesses, any short-term success typically dissipates as the time horizon increases.”

Supporting this, 96.4% of euro-denominated and 89.7% of sterling-denominated global equity funds were beaten by the S&P Global 1200 index over the past decade.

Furthermore, 94.9% and 94.7% of euro and sterling US equity funds were outstripped by the S&P 500 over the 10 years to the end of 2021, with this rising to 98.3% of euro-denominated US equity funds when measured on a risk-adjusted basis.

A turning tide?

A key challenge over the past decade has been the comfortable ride enjoyed by tech behemoths such as Apple, Microsoft and Amazon in the US amid a regime of low interest rates.

This has made it extremely difficult for all but a select few to outrun large cap US equity passive ETFs in the long run, even as active managers retain their consistent foothold of outperformance in areas such as UK small caps.

As central banks look to cool off the frenzied post-pandemic recovery and four-decade-high price growth, perhaps we might see an end to the growth-friendly epoch.

With this, might we see a switch in outcomes for active managers of different specialties, as old economy sectors find favour?

Seeing logic in this line of thought, Simon EvanCook, fund manager at Downing Fund Managers, told ETF Stream: “I would not be at all surprised to see the relative fortunes of US and UK active equity managers reverse over the next few years, as they have already begun to do this year.”

He argued the average UK equity manager has “trounced” the FTSE All-Share index over the last 10 years, given the benchmark is filled with banks, energy firms and resource companies, all of which have been deeply out of favour.

“That is a complete contrast to the US, where the increasing size of the tech titans in the index, and the tech sector in general, made it hard for a fundamentals-based manager to even match the index over the previous decade, let along beat it,” he continued.

“But if we see tech titans wobble, or even just mildly underperform, they will put significant downward pressure on the index, which will give active managers a far better chance of beating the market.”

However, Evan-Cook said the active managers’ ability to outperform in a longer-term higher interest rate environment depends on the specialty of those who survived what he described as the “Darwinian effect” of the last decade.

Indeed, SPIVA’s recent Europe scorecard shows only around half of the 1419 global equity funds, 426 US equity funds and 1178 Europe equity funds listed in the continent survived the ten years to the end of 2021.

Evan-Cook concluded: “It may take a value manager to beat the market for much of the 2020s but many of them were forced out of their jobs while others capitulated over to ‘growth’. This means the average manager might now be a growth manager, which could skew the stats if the value trend keeps running.”

Why an ETF?

Assuming the cards are played in active managers’ favour – there are higher rates for longer, the right managers to outperform during economic slowdown and most indices remain overweight struggling growth names – the next question an investor should rightly ask is why use an ETF over other structures?

While in the US the option of the non-transparent structure allows ETFs to guard their ‘secret sauce’ and the ETF structure in general offers tax advantages versus others such as mutual funds, neither of these advantages exists in Europe. In fact, in certain regions such as Spain, the tax advantage lies with mutual funds.

Additionally, if investors move away from open-ended vehicles, they can access more illiquid exposures such as small companies, venture opportunities and unlisted assets which are routes for non-correlation versus the large-cap securities that dominate ETFs.

In fact, even when ETFs capture small, listed companies, they must always keep an eye on liquidity, given creations and redemptions in popular products can dictate the performance of their underlying – and rebalances of relatively illiquid securities in transparent ETFs are prime targets for opportunistic hedge funds.

Despite these limitations, European investors remain convinced active ETFs represent an attractive proposition. At the start of 2022, Brown Brothers Harriman’s professional investor survey revealed 71% of European investors plan to increase their allocations to active ETFs over the next 12 months, up from 50% a year earlier.

Naturally, part of this owes to the underdeveloped state of the active ETF roster in Europe. As the product range continues to fill out, a truer picture of active ETF alpha during drawdowns will become available.

For now, years of underperformance appear to have done little to quell the Europeans’ enthusiasm for having a manager at the helm.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here

Related articles