Since 2005, investors have been placing greater amounts of money into passive based funds rather than actively managed mutual funds (Source: Morningstar). And that trend has been a profitable one as passive investing has significantly outperformed active stock picking during the past few years. For example, according to Wharton Research Data Services, less than 15% of US large company mutual funds have outperformed the S&P 500 index over the last three years ending June 30th 2016 and even less over the last five years.
What gives? Starting with the obvious answer, fees are much lower for index funds such as those that track the S&P 500. But we believe there is more to the underperformance story than just fees. First, the large cap universe is a highly transparent, highly efficient asset class with outperformance more likely to come from factor bets such as a dividend or sales growth than traditional bottoms up stock picking. Second, low interest rates and a disappointing global economy have tended to blur the growth potential and managerial differentials among companies. Third, following the 2008 financial crisis correlations among many sector and industries have unusually tightened. This observation may well be associated with investor fixation on central bank policy and the belief there is one stock market and not a market of stocks. Lastly, the sheer money flow into passive investments “lifts all boats” -i.e., if a stock is included in an index it is being purchased each time a new dollar buys that particular index thereby placing zero value on the “price discovery” role provided by an analyst.
Will the passive advantage continue? Maybe not. Excluding large cap investing where we prefer disciplined factor investing over pure active management we look for active managers in small cap, international, emerging market and high yield to stand a much better chance of outperforming their passive benchmarks during the next four years. Why do we feel a change is in the air? For one it didn’t take long for the investor sentiment to switch from the “glass is half empty to its now half full” after Trump’s election victory. You may even say the glass is overflowing based on the knee jerk bounce towards Dow 20,000. When sentiment or valuations get frothy discipline comes into play and an index knows no discipline. In a market weighted index, by definition, higher market value stocks will carry more weight. This truism may lead to abnormal selloffs and/or index underperformance vs. active managers when either the valuations of companies that comprise a disproportionate share of an index fall in price; economic conditions sharply deteriorate; rates significantly rise; or when the nation or world is dealing with an exogenous event. Unfortunately the frequencies of these corrections/unanticipated events seem to be accelerating (i.e. December 1972, October 1987, September 1998, March 2000, September 2001 and October 2007).
Next, interest rates may have bottomed and global growth is showing signs of accelerating. Heavily leveraged or poorly managed companies may no longer see their stock price benefit from indiscriminate investing habits. A Trump agenda that includes deregulation, infrastructure spending, corporate tax relief, potential trade wars and tariffs are all factors an index ignores. Surprise is another. In periods of uncertainty or surprise (i.e. the 2016 US presidential election) it would not be unexpected to see market volatility sharply rise. Volatility produces periods of short term dislocation in stock market prices which can allow active managers to add value. Price discovery—determining the present value of a particular stock—is a critical element in creating fair and transparent markets. We may be entering an environment where the cost of stock research more than offsets the incremental savings of owning only low cost index funds.
Should passive investments be completely liquidated? No. As a matter of fact, we believe they should not be viewed as mutually exclusive investment vehicles but rather owning both active and passive investments may make the most sense over a market cycle. We are just suggesting for those that are overweighed in the index camp you may want to give thought to adding active manager exposure.