Passivity Is The New Activity

Does active management ever have a role to play?
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In the long-running contest between actively managed mutual funds and passive index funds, a large majority of researchers and many investment professionals seem to have concluded that passively managed ETFs and index style mutual funds decisively beat active management. There is no question but that the vast majority of index-style funds have historically outperformed their actively-managed peers over virtually every relevant time period.

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A few years ago, at the annual American Finance Association conference, noted financial economist Ken French gave the keynote speech, and showed data indicating that after fees, expenses, and trading costs society pays to invest in the U.S. stock market, for the period 1980–2006, investors spent 0.67% of the aggregate value of the market each year searching for superior returns. That means the typical investor would increase his average annual return by 67 basis points over the 1980–2006 period if he switched to a passive market portfolio.

All of this begs the question – does active management ever have a role to play?

There are few possible answers to this question.

1. First, nearly every fund family out there in response to the active vs. passive debate immediately points to their top performing fund which consistently beats a benchmark.

There is no doubt that some mutual funds do a better job than others. In other words, skill definitely plays a role in performance. In particular, there is clear empirical evidence that mutual funds with significant negative alpha continue to have negative alpha in the future. Fund managers that are bad at their jobs generally remain bad at their jobs in the future (why they stay in business is less clear – it has probably got something to do with stickiness of particular groups of investor funds).

So skill clearly does matter.

2. Fees also matter. A couple of years ago, Morningstar introduced an innovative new metric for the active/passive debate based on measuring active fund managers against their peers. The Morningstar research found that actively traded funds were more likely to outperform passive when their fees were lower. In that sense, a big part of the benefits of passive management come from lower fees.

These two responses to the usefulness of active are deeply unsatisfying though. In particular, active managers often say that passive management outperforms when correlations are high and stocks are rising together. That makes some logical sense – in the extreme if all stocks rise at the same rate, then picking among stocks is fruitless.

So there might in theory be value in active stock picking when markets diverge. In my role as a university researcher in finance, recently did a study on this concept.

Investors can think about the type of investments they have based on the graphic below. Mutual funds in general operate on two dimensions – the degree of tracking error they have versus the broader markets and the degree to which the firm uses unsystematic stock picking.

Screen Shot 2017-02-09 at 1.34.06 PM

Both high tracking error and systematic stock selection can have their uses. High tracking error for instance is associated with factor investing – which has demonstrably superior returns to simple indexing.

The value in qualitative stock selection though is derived entirely from the skill of the manager doing the stock picking. The results from my study show that what’s going on in the overall economy has a substantial influence on the value of active management and stock picking.

When markets are healthy- valuations are within 1.5 standard deviations of the historical norms – passively managed index investments outperform actively managed funds by roughly 85 basis points on average. When markets are unhealthy meaning valuations are abnormally low or high, actively managed funds outperform passive funds.

The opportunity for actively managed investors appears to stem from volatility in the markets and the inefficiencies caused by market liquidity shocks. During these turbulent periods human investment manager can strategically select stocks or defensively position a portfolio mitigate risk and opportunistically capitalize on mispricing.

The best example of the opportunity for active managers is the period from 2000 to 2008, an eight-year span during which equity markets overall produced very low returns despite high levels of volatility. During this period two out of every three active managers outperformed the S&P 500 index. On average that type of market outcome only occurs about 15% of the time, but because of the serial correlations markets exhibit, such periods can stretch for years at a time as occurred during the 2000 to 2008 window. Of course, that also means that actively managed funds can go a decade or more consistently losing to passive funds.

The chart below shows hedge fund returns (perhaps the ultimate in high cost active management), and illustrates the importance of those funds capitalizing on market turbulence while they can. Hedge funds as a whole dramatically outperformed global stocks during the 2000-to-2008 window, but since 2008, broader equity markets have come roaring back. In fact much of the outperformance of hedge funds was built around minimized losses during the bursting of the dotcom bubble.

Screen Shot 2017-02-09 at 1.36.09 PM

So what’s the overall moral of the story? Two points stand out.

First, since investors never know what markets have in store in the future, maintaining a portfolio that includes active and passive management often makes sense. Factor investing can serve a valuable role in place of either active or passive.

Second, the only way that active management has historically succeeded in beating passive is by capitalizing on market inefficiencies caused by turbulence. Investors who want to benefit from active management need to have the stomach to endure years-long stretches of underperformance from that asset class and stomach churning volatility in the broader markets when the asset class does perform. In the absence of that kind of discipline, a passive approach is the best bet.

Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com

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