A Bronfman E.L. Rothschild Whitepaper
by: Robert Cron, Senior Portfolio Manager, Bronfman E.L. Rothschild
The active versus passive debate is a hot topic in the financial media. That’s no surprise given recent performance and a dramatic shift in investors’ preferences:
- For several years, the average passively managed fund has outperformed the average actively managed fund.
- According to Morningstar data, “passive investing is now the mainstream approach,”1 with about $2 flowing into passive vehicles for every $1 flowing into active vehicles. Furthermore, a substantial portion of the active flows are from target date funds in retirement accounts—not necessarily representing a specific, positive decision by the investor to choose active.
As investors’ preferences have changed, active investment styles have received “a public relations thrashing.” That’s from a column last year by Morningstar’s Vice President of Research John Rekenthaler, who went on to say: “Index-fund managers have convinced the marketplace that the critical investment issue is whether to be passive or active.”2
To make appropriate investment decisions, investors need to examine many parameters beyond just “active versus passive” as part of their fund selection process—such as fees, track records, current market conditions, and individual portfolio allocation needs. This paper will explore some of these issues, with specific attention to the fact that outperformance by either active or passive styles tends to occur in cycles.
Some history: the growth of passive funds
Passively managed index mutual funds and ETFs have proliferated. In 2004, there were only 150 ETFs. By 2014, there were 1300.3 According to Morningstar, the growth of fund flows to actively managed funds was a mere 2% over the past year, compared to 11% organic growth of flows to passive investment portfolios.4
Cash flows into passive funds now may have become sort of a self-fulfilling prophesy, because an index fund necessarily owns all companies in the index, even unprofitable ones. Large flows, therefore, can drive up stock prices without a fundamental reason.
Historical performance comparison
The recent string of wins by passively managed funds doesn’t tell the whole story.
It’s true that the average passively managed fund has outperformed the average actively managed fund in recent years. This has been true since 2008 and was especially notable in 2014 when less than 20% of actively managed funds beat their indices. While big stocks like Apple drove the index up more than 13% in 2014, the average stock was not up nearly as much. In addition, active managers with exposure to smaller companies or energy stocks faced significant headwinds.
However, the relative performance of active vs passive managers actually runs in cycles. According to Leuthold Group, last year the number of active managers underperforming the index has reached an extreme:
“Lipper estimates that 85% of active equity managers are trailing the S&P 500 on a YTD basis. Passive equity investing is probably more popular today than at any time since 2000—which, of course, was a terrible time to go passive.” – The Leuthold Group, Perception for the Professional, December 20145
While recent history has favored passive funds, active funds have had long stretches of outperformance. According to a February 2015 Wall Street Journal article, between 2000 and 2008, 63% of active managers outperformed their index benchmarks. According to the article, “Human managers sometimes do better in times when merely riding the market doesn’t work, and stock picking or defensive positioning is called for.”6
Periods of rising interest rates have, in particular, featured outperformance by active managers According to Barron’s:
From 1962 to 1981, when the 10-year Treasury yield more than tripled, from 3.85% to 15.8%, the median cumulative return for large-company mutual funds (including those that have since closed) was more than 62 percentage points better than the S&P 500, or an average of 3.2 percentage points per year. In other words, $10,000 invested in an active fund that earned the median return in that stretch would have $13,000 more than the same investment in an S&P 500 index fund. That lead reached 70 percentage points in 1983, then steadily eroded as interest rates headed down.7
While few active managers outperformed their index in 2014, the long term numbers are a little better with about 45% of active managers outperforming their index over the ten years ended in 2013.8
Why Choose an Actively Managed Fund?
At Bronfman E. L Rothschild, we seek to identify actively managed funds that can beat the market over the long term. We generally look for funds with good long-term track records with well-defined processes that charge belowaverage fees relative to peers.
Funds that meet those criteria may be especially useful in certain investor or market-related circumstances:
- In periods of volatility, an active manager can shift into or out of certain sectors. On the flip side, during periods of low volatility when most stocks are rising, it is harder for active managers to outperform. When there is not a lot of difference between the high performing and low performing stocks, it is hard to add significant value by selective stock picking.
- By their nature, many passive/index funds are skewed toward the largest stocks. This is because the indices are market-cap weighted, meaning the larger companies have a bigger weighting than smaller companies in the index. Given current valuations, the “typical” or median S&P 500 stock has either matched or exceeded valuation levels reached at the bull market tops of both 2000 and 2007 according to Leuthold Group.9
- For some investors, reducing volatility is a primary goal. In this case, we like to select active managers who are risk averse and we believe some can do a better job reducing volatility. We also seek to combine funds that are less correlated with each other or the market, potentially adding some additional downside protection.
- In some more specialized areas of the market that are less liquid and have fewer passive options, we prefer actively managed funds. For example, there are fewer passive options among emerging market debt funds. In this case, an actively managed fund may be the best choice. On the flip side, we will choose to use a passive or index fund when an actively-managed choice is not available. For example, due to their capacity constraints, many small cap funds close to new investors. We occasionally choose an index option if we do not have a small cap fund that meets our criteria and is open to new investors.
- Despite efficient market theory, we believe some sectors are less efficient or lack good information making it possible for active managers to outperform. In these cases, we seek astute managers with good track records and defined processes that we believe can outperform their indices over time. We look for funds that have concentrated holdings or have a unique process to find undervalued stocks.
- History suggests that active funds tend to outperform in periods of rising rates. As noted above, stocks tend to perform well during periods of declining rates. It is during these times when indexes tend to shine. However, when rates rise, stocks struggle, and active managers tend to outshine their index peers. According to Barron’s, active managers beat the index by 1.5 percentage points in the years in which rates moved higher and trail it by two percentage points in those in which rates fell.10
In our view, active products can fulfill an important place in most investors’ portfolios. We do not advocate abandoning active for passive altogether.
At Bronfman E. L Rothschild, we work with each client to determine long term goals and risk tolerance and construct a portfolio that is diversified across asset classes. In 2014, with U.S. equities significantly outperforming other asset classes for the second year in a row, some wondered why we even added other asset classes. However, we encourage clients to consider the historical performance of various asset classes. For more information about the benefits of a diversified portfolio, see our recent commentary. As we build diversified portfolios, we often select active funds that meet our criteria. When we can’t find an appropriate actively managed fund in one of the selected asset classes, we choose a passive fund instead.
Over time, we expect the active versus passive debate to shift to other more critical parameters, such as cost. Both active and passive funds can play important roles in portfolios. We’d echo the thoughts of a thoughtful article on this subject in Barron’s, in which Zachary Karabell of Envestnet concluded:
The two styles, in truth, are less Hatfield and McCoys and more yin and yang. Think about it: if theoretically, we woke up tomorrow and all investing were passive, there would be no stock movement, no alpha, no nothing. The only movement in prices would come from the flow of money in and out. Why mention this? The reason so many passive funds beat active is that active funds are managed by people who make mistakes or see their decisions go awry. Passive investing is thus the flip side of active and can only do well in a universe where there are active managers picking and choosing. Passive and active investing are thus twined, and the best strategy is to use both wisely and filter out the noise advocating one at the expense of the other.8
1 Rekenthaler, John. “Do Active Funds Have a Future?” Morningstar.com. August 6, 2014. http://news.morningstar.com/articlenet/article.aspx?id=659902
2 Rekenthaler, John. “Active Versus Passive Is the Wrong Question.” Morningstar.com. August 25, 2014. http://news.morningstar.com/articlenet/article.aspx?id=662733
3 Karabell, Zachary. “Solving the Active Vs. Passive Investing Debate,” Barrons.com. January 26, 2015. http://online.barrons.com/articles/solving-the-active-vs-passive-investing-debate-1422304950
5 The Leuthold Group, Perception for the Professional, December 2014.
6 “The Case for Actively Managed Funds,” Wall Street Journal, February 9, 2015. http://www.wsj.com/articles/the-case-for-actively-managedfunds-1423454485
7 Max, Sarah. “Return of the Stockpickers; Active managers are likely to recapture their lost glory as interest rates rise,” Barron’s, January 23, 2015. http://online.barrons.com/articles/return-of-the-mutual-fund-stockpickers-1420870199
8 Karabell, Zachary. “Solving the Active Vs. Passive Investing Debate,” Barrons.com. January 26, 2015. http://online.barrons.com/articles/solving-the-active-vs-passive-investing-debate-1422304950
9 The Leuthold Group, Perception Express, December 5, 2014.
10 “Max, Sarah. Return of the Stockpickers; Active managers are likely to recapture their lost glory as interest rates rise,” Barron’s, January 23, 2015. http://online.barrons.com/articles/return-of-the-mutual-fund-stockpickers-1420870199