Research

Active and Passive Money Management

A line between active and passive investment funds is set to cross next year.   Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds, and have allocated roughly $1.4 trillion to U.S. equity index funds and exchange-traded funds (ETFs).  When it comes to mutual funds and exchange-traded funds that buy U.S. stocks, those that passively track indexes now hold 48 percent of market assets according to estimates from  Morningstar Inc. According to Bloomberg, the passive funds will top 50 percent in 2019 if the current trend holds.  That would mark a tipping point for the investing industry, which for decades built its stature on the prowess of stock-and-bond pickers seeking to beat the markets.  In this KnowRisk Report, we want to show the full picture of this trend with the pluses and the minuses because there are both.

In recent years, investors have been ditching those active managers in favor of ETFs and other index funds, which typically offer a way to get market exposure at lower fees.  The trend continues.  The late John Bogle, the inventor of the index fund, states [emphasis added]:

“One development could mitigate much of the advantage that index funds enjoy and slow the rush to own them, but you’re probably not going to like it. When the market suffers a prolonged decline, active managers can gain an edge over indexers by moving large portions of assets into cash or into defensive sectors such as utilities and consumer staples. Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone. Until the next bear market, the indexing trend is likely to accelerate. As with any tragedy of the commons, indexing is the sensible thing for each individual to do, but each individual should remember that many sensible ideas, especially in investing, make less sense as more people put them into practice. When the stock market turns down again, index fund owners will have to become their own active manager and make sure they’re well diversified, with limited exposure to risk, chaos, and catastrophe.”

We use both active and passive investments at Equitas. One of the benefits to the growing trend towards passive investing is lower fees to the investor. Not only do the passive ETFs generally charge lower fees, but the competition is driving fees lower among active managers. Sophisticated investors should seek active managers in asset classes with low efficiency and high dispersion, and look to passive investing in the most efficient asset classes.

Below is some research from the Equitas analysts on the cyclicality of active and passive investing. These are the net annualized return numbers for the last 20 years for the Standard and Poor’s S&P 500 ETF, the Vanguard S&P 500 Index Fund, the actual S&P Index, and the entire Morningstar Universe of all domestic stock managers shown annualized over rolling periods and year by year from 1998 to 2017. Remember, unlike test grading in school, a money manager universe ranking lists 1 as the best and 100 as the worst.

Morningstar Database – US EQUITY ALL CAP UNIVERSE

We thought it interesting to see the cyclicality of the swings.  Some years the index is in the 12th percentile, meaning the index beat 88% of the active managers.  Some years the index is in the 72nd percentile, meaning that 72% of the active managers beat the index.  The index funds tend to track the index closely but underperform slightly by the amount of the fees and other fund costs. 

Note the median manager in the Morningstar database underperformed the index for all the rolling periods for this bull market for the last 10 years, but over performed for the last 20 year period that includes the big bear market starting in 2000.  Bull markets tend to favor index funds while bear markets tend to favor active funds according to John Bogle.  We just finished 10 years of a bull market and we are not sure what the future holds.  However, there is a concept called “gravitation to the mean” which tends to kick in after prolonged periods of market movement in either direction and pull market returns back to the long term average. 

There is another effect from a 50/50 mix of active and passive management. This 50/50 ratio effectively takes half of the buying power out of the market.  A good active manager may research an attractive company with terrific fundamentals, but the passive half of the market does not care about fundamentals and just buys across the board based on company size.  Conversely, when investors go bearish and decide to sell, they tend to move as a group, sometimes known as “the thundering herd.”  When the herd stampedes out of the passive investments, the active half the market may not be interested in buying the entire index of stocks, and prefers to cherry pick the ones perceived to have good fundamental characteristics. The concentration in the market has gone up with passive managers the largest shareholder in at least 40% of all U.S. listed companies. Further, this concentration raises concern about new financial risks including increased investor herding and greater volatility in times of severe financial instabilities.  There may indeed be opportunities imbedded in this new risk, but what appears clearer is that we may be experiencing increased volatility in the market going forward. 

Bear Market Breakdown

On March 24, 2000 when the tech bubble peaked, this particular downturn lasted roughly two and a half years, bottoming on October 10, 2002.  In this bear market, returns between different stocks were less correlated, meaning they did not move in the same direction at the same time, with much of the losses concentrated in the technology sector and in the largest capitalization stocks. Thus, active equity managers had the opportunity to differentiate their returns relative to the market. For example, while the cap-weighted S&P 500 declined 47% from peak to trough, the equal-weighted S&P 500 only declined 26%, a notable divergence.

The second major drawdown occurred during the Great Financial Crisis (GFC) and began on October 9, 2007 when the S&P 500 made its closing high for that cycle. The downturn lasted about a year and a half, bottoming on March 9, 2009.    It was more difficult to protected capital well in this drawdown than in the 2000-2002 bear market, as price weakness was more widespread during the GFC. As a proof point, the equal-weighted S&P index declined 59% from peak to trough during this drawdown compared to the 55% decline for the cap-weighted version. We remain concerned that a similar occurrence is possible when the next bear market in equities inevitably arrives, and we want our clients prepared for this possibility.

Relative to actively managed funds, the assets under management of passive indices has risen dramatically over the past ten years, a trend seen both inside and outside of the U.S.  Regardless of one’s opinion about the merits of passive investing, we believe there should be little debate that they are essentially “momentum” strategies, systematically buying when money flows in, and selling when money flows out. 

J.P. Morgan estimates that 90% of current equity trading volume comes from “trend-following” traders (quant, index, ETFs, futures and options-related strategies) whose trading decisions are often driven by algorithmic or programmatic reasons rather than fundamental ones.   The remaining 10% is comprised of active traders, i.e. active managers, who act as a natural floor for equity prices because they often buy into share price weakness.  The decline in fundamental, active traders as a percentage of U.S. equity volume began in earnest around 2003.    This fact may  also help  explain why  correlations in price  returns were  much  higher  in the  2007-2009 bear  market compared to the  2000-2002 bear market, as the percentage of equity trading volume derived from “active” traders declined substantially in the  period between these  two market drawdowns.

All the major stock exchanges work as an auction market, where buyers place bids to buy, and sellers place offers to sell.  The mid-point of the bid and ask prices is the equilibrium price for the stock.  An efficient system that works well as long as there are both buyers and sellers lined up with different opinions on the value of the stock.  An auction market breaks down when there is no one on the other side of the transaction.  This is part of John Bogle’s warning.  Mr. Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. However, past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place. Trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues.  “If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo Finance at the Berkshire Hathaway annual meeting. “The markets would fail,” he added.

We want readers to have this information in order to make informed decisions in your own best interest. That is always our goal at Equitas.

In 2002 Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.

Disclosures and Disclaimers:

Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.

Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.

Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.

Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.

All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.