23 May 2018
A key feature of the current equity bull market has been the inexorable rise of passive strategies. These have gathered significant assets under management at the expense of active managers. This note explores the cyclical nature of passive and active performance and highlights the potential for active managers to benefit from a turn in the tide, as valuation returns to prominence.
Passive strategies have played a leading role in the stockmarket rally that began in the depths of the financial crisis. This was most notable in the US, where index funds have doubled their share of the world’s biggest and most liquid market. As the chart below illustrates, passive’s share of the US market has increased from about 20% in 2009 to more than 40% today, whereas active managers have lost ground.
With this trend in place, it is no surprise that Vanguard Group, the US mutual funds company founded by the pioneer of passive investing John Bogle, has been the fastest-growing asset manager in the world for the past six years. Vanguard attracted a staggering US$1 billion in new business for each day of 2017, with 90% of net inflows directed towards tracker funds. Index funds have established themselves as an integral part of the investment landscape.
Tracker funds certainly have their appeal, with their low costs and the simplicity of their investment approach. But their emergence as the dominant money-taker also coincides with a time when passive strategies outperformed active ones. Index funds delivered higher returns in seven out of the last nine years, as the table below illustrates. Trackers were better placed to capture the upside in a rising market fuelled by growth and momentum; active managers suffered as valuation was largely ignored.
Figure 1. Assets under management of US funds
Active vs passive, 2009 – Feb 2018
Source: Strategic Insight SimFund, BofA Merrill Lynch US Equity & US Quant Strategy, 25 April 2018
| Year | Morningstar Active Large Blend (%) | S&P 500 Index Funds (%) |
|---|---|---|
| 2017 | 20.05 | 21.26 |
| 2016 | 10.21 | 11.42 |
| 2015 | -0.98 | 0.89 |
| 2014 | 11.13 | 13.08 |
| 2013 | 32.20 | 31.71 |
| 2012 | 15.29 | 15.41 |
| 2011 | -0.60 | 1.62 |
| 2010 | 14.09 | 14.50 |
| 2009 | 28.88 | 25.98 |
Source: Morningstar Direct, January 2018
Please note, past performance is not a guide to future performance.
With such a favourable performance tailwind, the stampede into index funds is easy to understand, if only from a backward-looking perspective. However, past performance is not a guide to future performance, and we would caution against extrapolating from recent trends. For it was not always thus.
Recent bias tends to exaggerate the importance of our most recent experience – but history shows that index funds have not always outperformed. The nine years prior to the current bull market, going back to the peak of the technology bubble, saw active funds delivering superior returns in all but one year. In some cases, the magnitude of the outperformance was striking. The bursting of the technology bubble in 2000 was one instance when being selective worked in the investor’s favour.
| Year | Morningstar Active Large Blend (%) | S&P 500 Index Funds (%) |
|---|---|---|
| 2008 | -36.92 | -37.26 |
| 2007 | 7.03 | 4.97 |
| 2006 | 14.52 | 15.19 |
| 2005 | 6.82 | 4.41 |
| 2004 | 10.98 | 10.32 |
| 2003 | 28.85 | 27.96 |
| 2002 | -20.15 | -22.46 |
| 2001 | -8.54 | -12.35 |
| 2000 | -0.26 | -9.45 |
Source: Morningstar Direct, January 2018
The 1990s, on the other hand, experienced a similar pattern to the current bull market; passive outperformed active in seven out of 10 years.
Observing stockmarkets from a multi-decade perspective, we conclude that the performance of active and passive investing moves in cycles. It would be wrong to dismiss active management as structurally flawed, in our view. We would also highlight that the outperformance of passive strategies is close to its historic highs and the underperformance of active strategies is near an all-time low – demonstrated by Figure 2. If our assertion of active versus passive performance being cyclical is correct, mean reversion should result in the outperformance of active strategies in the years to come. The good times for passive won’t last forever.
Figure 2. Active vs passive investing
Rolling monthly 3-year periods, 1985 – 2017
Source: Morningstar Direct, January 2018
Please note, past performance is not a guide to future performance.
Figure 3. Valuation dispersion in the S&P 500
Source: Factset, BofA Merrill Lynch US Equity & US Quant Strategy, 25 April 2018
Please note, past performance is not a guide to future performance.
The importance of valuation to long-term equity returns points to a more favourable environment for active managers. Valuation dispersions across the market are comfortably above the long-term average (see Figure 3), and history shows that periods of narrowing dispersions coincide with active strategies outperforming. Although the disparities are not as extreme as they were in 2000 and 2009, falling dispersions should be conducive for active managers to generate alpha through stock selection.
In recent years, active managers have struggled to keep up with a rising market driven by growth and momentum, but we see potential for the circumstances to change. There are reasons to be optimistic. The cyclical nature of active and passive performance, coupled with valuation dispersions favourable for alpha generation, provides an opportunity for active managers to outperform. Ultimately, the success of active managers will be determined by the strength of individual strategies and their investment edge. We believe the application of skill and the backing of conviction can deliver attractive returns ahead of their passive counterparts in the years to come.
Investors are reminded that the value of investments and the income from them will fluctuate, and you may not get back the amount you originally invested.
M&G
May 2018