Active managers for U.S. stock-market portfolios, who have struggled amid a decade long exodus from their funds, are gunning for something of a detente with their increasingly dominant passive-investing rivals, putting out a new message for investors: it isn't us or them, it's us and them.
Seizing upon a market environment that they argue is more hospitable for active management, as well as a recent streak of improved performance that would seem to support that claim, managers are touting what they see as the benefits of a portfolio that includes both strategies.
It is a notable shift, reflecting an acceptance of the reality that passive is here to stay, and that stock pickers, once-dominant on Wall Street, were serving a more niche or diversifying role.
In an actively managed portfolio, the components are selected at the discretion of an individual or team. This is in contrast to a passive fund, which mimic the performance of an index like the S&P 500 (.SPX) by holding the same stocks the index does, and in the same proportion. Active managers argue they can outperform the overall market through security selection, but data have repeatedly demonstrated that few can achieve this feat over the long term, although there are short-term fluctuations, as during the recent market pullback.
The current environment is seen as one that could offer better opportunity for active managers. Stock correlations — despite a recent spike — have been at multiyear lows, leading to what some have dubbed a "stock picker's market." Low correlations mean individual securities are moving on their own fundamentals, as opposed to macroeconomic conditions leading all stocks to move in similar ways, as had been the case for years in the post-financial-crisis recovery.
Furthermore, active managers say they are better equipped to handle the expected market outlook over the coming years. Stock valuations are stretched by many metrics, and the Federal Reserve is both raising interest rates and shrinking its balance sheet, removing factors that have fueled equity gains for years. Both of those issues, along with uncertainty regarding trade policy, could exacerbate market volatility going forward, which managers argue they can avoid or temper through security selection.
"The Fed front-loaded 20 years of stock gains into the past decade, that's bad for passive but good for active," wrote Barry Bannister, head of institutional equity strategy at Stifel (emphasis in original). Bannister recently warned that any policy mistakes by the Fed could spark an "unusually rapid" bear market, along with a "lost decade" for stocks. Under such a scenario, the S&P 500 would return 0% in the 10-year period between 2018 and 2027. However, not every stock would perform that way, and in Bannister's estimation, an active manager could outperform by identifying the winners.
This view has been echoed across Wall Street, albeit, often by active shops who have been seeing new flows favor passive firms.
"Investors who commit too much to passive — and not enough to active — could face mounting risks," AllianceBernstein wrote in a recent research report. The firm cited the idea that the growing popularity of passive strategies was creating market inefficiencies and skewing the valuations of stocks.
While this view has been disputed by advocates of passive investing, it has taken on new urgency as passive steamrolls over active in popularity. Vanguard, an asset-managing firm that is famous for its advocacy of passive, has seen inflows of nearly $170 billion over the past year, more than all other fund families combined, according to an analysis of Morningstar Direct data. (Just eight firms had positive inflows.)
Jeffrey Saut, chief investment strategist at Raymond James, recently wrote that "we have been advocating active over passive management for about a year." He quoted a small-cap portfolio manager he spoke to, who cited the falling correlations as a reason to move away from passive: "Dispersion among individual issues within small-caps will only increase, and active managers might actually be useful in identifying those companies that can succeed spectacularly. Most importantly, this scenario will go on not just for one year, but for probably 5-10 years."
Even passive firms have expressed some sympathy for the active-passive approach. According to the Wall Street Journal, State Street Corp. is encouraging investors to "go active," expecting it to perform better in an environment that is likely to be volatile, and where the impact of the recently passed tax law remains to be fully seen. State Street sponsors the SPDR suite of ETFs, some of the most popular passive products on the market.
The better long-term performance of passive funds, along with their lower fees, have led to a major shift in how investors access the market. According to Morningstar Direct, $573.2 billion has flowed into passive U.S. stock funds (both mutual funds and exchange-traded funds) over the past 12 months, while $28.7 billion has gone into actively managed ones. Those slight inflows represent something of a victory for actively managed products, as outflows have been consistent for years.
That change could represent optimism over active's prospects, underlined by their recent relative outperformance. According to Natixis Investment Managers, "Investors whose portfolios tilted toward active investments performed slightly better than those more reliant on passive in 2017." However, the difference was negligible: a gain of 15% for active versus 14.4% for passive-weighted portfolio, the kind of difference that can be erased through the higher fees of active products.