I have been studying and practicing investment management for almost 20 years, and the debate surrounding active versus passive investing has been raging for the entirety of that experience. Throughout history (and generally speaking), there has been little proof that one is superior to the other. Both sides can cite time periods where one beats the other or point to segments of the market that prove their approach is superior to the other.
It is becoming clearer that active management has the opportunity to be more successful in certain asset classes and may face more headwinds in others. To be more specific, if you look at different asset classes across fixed income and equity, you’ll see that the case for active/passive management is really quite different, depending on the asset class and market environment.
Note: All of the return analysis charts in this post show “index percentage in peer universe,” which is the percentile rank of an index in its peer universe. A higher number signifies the benchmark is doing worse relative to its peer group.
Despite all the hype about passive investing, high yield is an asset class where a true passive alternative does not really exist. Many of the issues are too small and the market is highly illiquid, making it impossible to construct a high-yield index fund. However, the median manager performance is somewhat competitive with the benchmark itself over time. Looking at the index ranking in its peer universe, we can conclude in this case that active management is superior.. This story is consistent in other asset classes with similar liquidity and replication characteristics, like emerging markets debt.
Core fixed income
Core fixed income is a more liquid and efficient fixed-income asset class. Here, we can build an index fund that is fairly successful in mirroring the index. However, it can’t be built out bond by bond, like an equity index. The index is built through sampling strategies constructed to very closely and fairly granularly mimic the broad characteristic of the benchmark. Still, the median manager is fairly successful in outperforming both the benchmark and the passive alternative. Also note the index appears essentially as a fourth-quartile performer in the peer universe. Therefore, we can conclude that active management works in the core-fixed income asset class.
U.S. small-cap equity
U.S. small cap is an asset class where the index is easily replicated on a security-by-security basis. The median manager returns tend to be fairly substantial relative to the benchmarks and fairly persistent with most market cycles. This is an asset class where there is clearly some inefficiency, and stock picking can really matter and add value to the relative benchmark.
U.S. large cap
U.S. large cap is a bit of an outlier – here, you can build index-like portfolios more easily than any other asset class. The median manager returns – and this might surprise some people – are competitive with benchmark. Over long periods of time, you can see almost 50ish basis points of out-performance, relative to the benchmark. Over time, the benchmark itself is right about in the middle of the pack, meaning that there is a 50/50 chance the active manager outperformed the benchmark. This is the challenge. This is the asset class that we will dive into more deeply in part 2 of this blog, looking at conditions that drive environments that are more or less favorable for active and passive investing.
Until next time
We have looked at a range of asset classes. Active management has demonstrated success in most asset classes and market conditions, but U.S. large-cap has been particularly challenged in the post-crisis period. We believe that this is a cyclical pattern, not a permanent paradigm shift in the structure of the market.
Next time, we will identify 5 factors that have driven the relationship between active and passive management, look at how those factors and the relationship have changed over time in a cyclical manner and, finally, illustrate why we believe the factors are going to shift to favor active management in the future.
High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.