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(Don’t) Call It a Comeback
The Return of Active Management?
Note: an edited version of this article originally appeared on ETF.com.
With each new article reporting on the exodus of investor flows out of active and into passive funds (see “The Dying Business of Picking Stocks” published in the Wall Street Journal), I suspect we are reaching the maximum pain point for investors who have stuck with active management despite the perennial underperformance versus passive, market-cap weighted benchmarks. As is often the case, the moment the last investor throws in the towel on a strategy is the moment when the maximum pain point threshold has been reached followed by a turnaround in that strategy’s fortunes. We may be reaching that point with active management.
The third quarter of this year brought some respite for active management. As a proxy for active management, I constructed a refined list of active U.S. large blend mutual funds in Morningstar where I screen out multiple share classes, sector funds, passive funds, and low/managed volatility. I believe how active core/blend funds perform against the S&P 500 serves as a pretty good proxy for active management in general because the same forces benefiting a cap-weighted index are also likely benefiting other cap-weighted benchmarks (i.e. small caps) regardless of the perceived degree of market inefficiency. Exhibit 1 displays the percentile rank (1=best) of the S&P 500 versus this active large core universe (356 funds) for time periods ending 9/30/2016. The S&P performed at the 57th percentile, a deterioration in rank from the 10-30% levels seen in all other time periods. Hedge fund performance has also recovered with the HFRI Global Index up 2.18% for the quarter and Prequin reporting a 4.06% return for its All Strategies Hedge Fund Index.
Exhibit 1 – S&P 500 Lags Behind in the 3rd Quarter
Indeed, the winds may be shifting for traditional active management as factors that tend to favor active management, such as size (smaller caps) and value, are turning into tailwinds from headwinds. Using Fama/French research factor return history, I constructed a large cap factor composite model combining size, value, and conservative investment, and profitability as a proxy for how active managers tend to invest. This composite makes intuitive sense because most active managers invest away from a cap-weighted benchmark (smaller companies) and focus on attributes that make intuitive sense (attractive stocks are either cheaper, more profitable, and/or more shareholder-friendly through their capital decisions). Exhibit 2 tracks the rolling 5-year relative performance of this composite against the S&P 500 (rolling 5-year periods beginning 1999 and ending in August 2016). Starting in 2005, this composite began to lag the S&P 500 – attributes that had provided tailwinds for active management began to turn into headwinds. Referring to Exhibit 1, one can note that the S&P 500 has dominated overall all trailing time periods going back to 2005. I don’t think this is a coincidence.
Also notice that over the more recent time periods, the composite’s relative performance against the S&P 500 turned negative for the first time over this time period. Now this could either be a confirmation that the premiums associated with Fama/French factors no longer exist or we have reached the maximum pain point for active management. I’m inclined to believe the latter. However, these factor headwinds may be turning into headwinds as the relative performance of this composite has started to hook up; perhaps an indication that the cycle is about to turn for active management.
Exhibit 2 – Factor Headwinds Turning into Tailwinds?
(Don’t) Call It a Comeback
With apologies to LL Cool J, traditional active management should start to work again if this cycle of smaller, more value-driven style of outperformance were to persist, but don’t call it a comeback. In a prior ETF.com post (“In Defense of Active Management (Sort of)”), we wrote:
“By isolating the common factor risks embedded within traditional active management, investors can better understand the value that is being delivered from a mutual fund manager’s investment insight. The challenge then for active managers is to deliver performance that is not easily replicated with strategic beta ETFs; otherwise, investors can gain much of the returns of ‘active management’ at a fraction of the cost of what typical active mutual funds are charging.”
As the Wall Street Journal article made clear, institutional and retail investors continue to move funds to lower cost, passive strategies and away from more expensive active strategies, whether traditional stock pickers or trade-centric hedge funds. Even if this exodus away from active management is laced with poor timing (not a surprise if anyone has read any of the CRSP or DALBAR studies), the asset management industry has been fundamentally transformed with the advent of ETFs. The landscape has changed for how and at what cost traditional active management delivers value to its client base.
ETFs have blown off the cover of active management as smart beta ETFs have confirmed what Fama/French have maintained all along – namely that much of what you get from traditional active management can be delivered more cheaply and consistently with factor-based portfolios (whether ETFs or Dimensional Fund Advisors (“DFA”)). Gone are the days that fund managers can pitch a common investment style under the guise of superior stock-picking stills. Even if we are about to enter a new cycle favoring active managers over passive, active managers will need to 1) lower their fees at a smaller premium to what can be more effectively gained in ETFs/DFA and 2) further distinguish the idiosyncratic aspects of their security selection skills from common factor behavior. No longer can a manager blame the market (i.e. ‘style is out of favor’ or ‘this is a low-quality rally’) for underperformance; nor can a manager take credit for outperformance that can be better attributed to smart beta factors.
Regardless, smart beta ETFs can at least confirm whether a particular manager’s style is experiencing headwinds or tailwinds.
So, here’s to the return of active management. We’ve written several times on the societal benefits that come with expert, professional pricing of equity and debt as well as holding company management accountable for their capital allocation decisions. Yet, the industry will continue to face consolidation partly due to regulation (i.e. the new Department of Labor Fiduciary Rules for advising retirement assets) and to cost competitiveness of smart beta alternatives. And active managers will need to further differentiate their approaches apart from those that can be replicated using smart beta ETFs.
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By: Benjamin Lavine