Thoughts from Our Domestic Equity Team
A recent Wall Street Journal article(1) highlighted the ongoing shift by equity investors from actively managed mutual funds to passively managed exchange-traded funds. The drivers of this change are the lower fees offered by exchange-traded funds and the poor performance of many active managers relative to their benchmark stock indices. The facts are indisputable. The shift to passive management is visible in flow of funds data.(2) On average, passive manager fees are half of active manager fees.(3) And academic studies confirm that active managers collectively underperform their benchmark indices over long periods.(4) With all this in mind, will the entire equity market eventually transition to index funds, or is there a meaningful role for active equity strategies in investment management?
First, while the fee gap between active and passive management appears large on a percentage basis, the absolute difference is quite small. Thus an active manager would not have to outperform a passive manager by much to provide the investor with a greater net total return. Second, while active managers on average underperform their benchmarks, some have delivered long-term records of outperformance by utilizing a consistent, repeatable process. For investors with limited resources, identifying these managers may be too difficult and therefore passive equity exposure could make sense. However, investors with a sufficient level of assets can partner with a financial advisor to perform manager selection. Financial advisors and their firms perform due diligence on managers and assess whether historical outperformance was generated by a stable team of investment professionals utilizing a consistent process, and may therefore be repeatable. Typically these strategies will have a relatively concentrated number of holdings, as buying shares in hundreds of individual stocks tends to produce returns similar to the benchmark. Similarly, smaller firms may be preferable to the largest players, as it becomes impossible to invest hundreds of billions of dollars in equities without mirroring the broader market.(5)
The move to passive management is happening alongside another, related phenomenon: a reallocation of funds away from equities and into fixed income.(6) This trend continues despite equity markets more than doubling since the bottom four years ago, while fixed income returned less than a quarter of that amount.(7) There are structural factors at play, including an aging demographic that requires a reduced risk profile and a historical overweighting of equities in retail portfolios which is slowly rebalancing. However these drivers have been exacerbated by sentiment. Investors are wary of the extreme volatility which can accompany equity returns, with the pain of the 2008 financial crisis still fresh in many minds. Additionally, events like the botched Facebook offering and the rise of high-frequency trading have led investors to question whether there is a level playing field in equity markets. In this context, active strategies may be preferable if financial advisors recommend equity managers who focus on delivering equity-like returns with lower risk and less volatility than index funds. After all, index funds are not a superior alternative for equity exposure if investors cannot stick with them to experience the upside.(8) The concern about a level playing field may be also addressed by relying on savvy active managers who use fundamental research to guide their individual stock selection.
While it is currently in vogue to be critical of active equity management, certain strategies that fall under that broad umbrella may still offer excellent prospects for many investors. In particular, by partnering with financial advisors to select strategies with consistent, repeatable processes that have historically outperformed over market cycles, investors position themselves well for the future. Moreover, by utilizing managers who seek to deliver equity-like returns with reduced risk, investors are more likely to stay invested in periods of macroeconomic shock and ultimately benefit when markets rebound.
(1) Grind, Kirsten. “Investors Sour on Pro Stock Pickers.” Wall Street Journal. January 4, 2013.
(2) In the first eleven months of 2012, U.S. active equity outflows were $115 billion, while U.S. passive equity inflows were $29 billion. Source: Morningstar.
(3) The median U.S. stock index fund charges 0.59% in annual expenses, while the median actively managed U.S. stock fund charges 1.16% annually. Source: Morningstar, Wall Street Journal.
(4) See for example, Jensen, Michael. “The Performance of Mutual Funds in the Period 1945-1964. Journal of Finance. 1968.
(5) The three-year correlation of the ten largest actively managed equities funds to their benchmark indices was 98% as of September 30, 2012, up from 91% in 2007. Source: Investment News.
(6) In the first eleven months of 2012, bond fund inflows were $350 billion, while equity fund outflows were $25 billion. Source: Morningstar.
(7) From March 9, 2009 to December 31, 2012, the S&P 500 total return was +129% while the Barclays U.S. Aggregate Bond Index total return was +28%. Source: Bloomberg.
(8) In the ten years ended December 31, 2009, the average U.S. equity mutual fund returned +1.59% but the average investor in the fund only earned +0.22%. The lower returns realized by investors were due to poorly timed buying and selling of the funds. The return differentials were widest for the funds with the highest volatility, suggesting that investors are more likely to mistime investments in strategies that take on more risk. Source: Morningstar.
Submitted by: Jason Benowitz, CFA – Portfolio Manager
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