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3D/L and EQIS come together to form Freedom Advisors

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The Return of Active Management? (Updated May 2018)

Benjamin M. Lavine, CFA, CAIA

We are publishing a quick update to our thoughts on traditional active management; the so-called active vs passive debate that has been written ad nauseum throughout the financial press.  We are writing this piece in advance of an upcoming Advisor Success Series podcast with a small/mid-cap portfolio manager who will provide his perspectives on the state of traditional active management and what he believes are some of the key ingredients to success in adding value for the firm’s investors. 

The major index providers (MSCI and S&P) have published updated pieces on how active managers have been faring against their style benchmarks (see here and here).  Overall, the recent trends for active outperformance appear to be improving as fund managers have generally benefited from a low volatile, upward trending market that has also produced higher security level performance dispersion across major markets.  In a prior piece, we surmised that much of this recent success has more to do with how managers have positioned around the technology sector (which handily outperformed all other sectors in 2017) rather than superior security selection.  That said, credit should be given to traditional managers who have seemed to slow the tide of passive indexing dominance. 

We would point readers to “The Return of Active Management?” published by 3D in October 2016 in response to a Wall Street Journal article that asked somewhat rhetorically whether we are witnessing “The Dying Business of Picking Stocks.” In our response article, we suggested that we had reached the maximum pain point for investors in traditional active funds who had suffered with inconsistent performance and excess fees.  We surmised that when a maximum pain threshold has been reached, a reversal in sentiment typically follows.  This occurs quite frequently in investing and it’s likely a major driver of historical risk premiums, where those premiums are earned precisely at those points where investors become exhausted with taking on risk

In looking back over the year-and-a-half period following these articles, the jury is still out on whether we’ve seen a reversal of fortunes for traditional active management.  According to Morningstar, investors continue to pull more money out of active funds versus passive funds with active U.S. equity funds suffering net outflows of $205.58 billion over the past year versus net inflows of $158.88 billion into passive U.S. equity funds for the period ending 3/31/2018.  The net inflow picture looks better for international equity and global fixed income asset classes, but passive funds still dominate fund flows across most asset categories.  Clearly investors and advisors are choosing low cost passive over the siren call of superior stock picking (net of fees), and judging from a flows standpoint, we’ve not yet seen a reversal of fortune for active management.     

How have active managers performed versus their respective benchmarks since we published “Return of Active Management”?  As a proxy for active management, we constructed a refined list of active U.S. large cap mutual funds in Morningstar where we screen out multiple share classes, sector funds, passive funds, and low/managed volatility and then measure their performance against their respective style benchmarks (i.e. S&P 500 Index for the Core/Blend category).  In addition, our analysis of active performance may be impacted by survivorship and selection biases although these biases will have a marginal impact given the relatively short time periods cited in the charts below.  The performance shown reflects net asset value performance that incorporates fund expenses.  Finally, we believe how active large cap funds perform against their respective style benchmarks 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. 

The three charts below show the percentile distribution of returns for the large cap growth, value, and core/blend categories.  We show year-to-date performance and 2-year annualized performance through 4/30/2018.  We chose 2-year annualized performance to capture most of time horizon since we published “The Return of Active Management”. 

Figures 1a, 1b, 1c – Active Large Cap Mutual Funds vs. Style Benchmarks: Percentile Distribution of Performance

Similar to what was observed in 2017, large cap value managers are faring better against the style benchmark followed by large growth, where the style benchmark is hovering around the median.  Large core/blend funds are still struggling against the S&P 500 Index.

Note also the tight dispersion around the 25th versus 75th percentiles that points to a narrow clustering of performance, implying that manager selection will have a marginal impact on total returns (unless you happen to have extreme fortune or misfortune of allocating to the 5th or 95th percentile manager).  

In addition to positioning in technology stocks, active managers who are outperforming are likely benefiting from a tailwind from ‘momentum’ style investing.  MSCI USA Momentum Index is up 3.59% year-to-date through the end of April, which would put in the top decile for the large core and large value fund universes and near the top quartile for large growth.  If ‘momentum’ were to suddenly reverse (due to a deflationary shock), it will be interesting to see whether active managers can maintain their outperformance. 

So has active management come back?   October 2016 will probably represent the point at which we saw extreme sentiment reached against active management in favor of passive, but active management will likely recover but in a different form with fewer players and lower fees.  One concern that investors should keep watch is a sudden turn in the risk regime where macro risk factors will dominate company level risks.  Active managers are subject to the whims and forces of macro risk regimes, and no amount of skill can overcome these forces. 

When it comes to active versus passive, 3D’s position is that both play a role in an investment program, whether in asset allocation or security selection.  Our position is that much of what is ‘delivered’ by traditional active management can be systematically captured through risk-based portfolio construction using factor strategies. 

We’ve argued in the past that the active decision to invest away from a cap-weighted benchmark (i.e. the S&P 500 Index and the Bloomberg/Barclays Aggregate Bond Index) should be borne by the asset allocator and that active managers should be measured against more refined benchmarks reflecting the systematic risks posed by their investment strategies.  Whether investing in traditional actively-managed strategies or smart beta indices, investors need to own more of the resulting asset allocation, primarily the residual performance stemming from the choice to invest away from market capitalization-weighted indices.  Active managers should not be given credit or assigned blame on areas outside of their control. 

Make sure to tune in to our upcoming podcast which will be broadcast within the next couple of weeks.

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of May 23, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing sales@3dadvisor.com or visiting 3D’s website atwww.3dadvisor.com.

By: Benjamin Lavine