Last week, we looked at a range of different asset classes across fixed income and equity to show that the debate about active/passive management is really quite different, depending on the asset class.
With that said, we are currently experiencing a long (7 years) “pro passive” cyclical environment that has led to passive investing gaining industry momentum. This trend has garnered the attention of the media and, therefore, investors. Many of you are probably dealing with the associated challenges today, particularly in large-cap equity, and asking yourselves if you should make a change.
So let’s take a deeper dive into the cyclicality of active management and try to understand the drivers that have led to strong passive performance in recent years.
Cyclicality of active management
The chart below shows 3-year rolling alphas of active managers, relative to the Russell 1000 benchmark, going back a little over 30 years. The gray-shaded area signifies periods where active was favored and the red areas signify periods where passive was favored. This illustration demonstrates that the success of active and passive management is a cyclical phenomenon in the equity markets.
In the early 80s, there was a fair degree of success, relative to benchmarks, in terms of alpha generation. Then in late 90s, during the tech bubble, we saw some underperformance. Between crises in the 2000s, we saw some very significant alpha generation. Most recently, we see substantial underperformance in alpha generation from the manager universe. It is interesting to note that we witnessed a similar alpha blight during the tech bubble run-up in the late 90s, where a disconnect emerged between underlying fundamentals of companies’ performance and the prices at which they trade in the marketplace. We think that most of what is driving this dislocation or headwind for active management is monetary policy – but before we get to policy, let’s look at factors that favor passive investing.
Factors favoring passive
We surveyed of a broad scope of literature – it seems that everyone is sharing a point of view in the active vs. passive debate. The academic community and Wall Street have come out with fairly unbiased views of this discussion; those are the sources that fed our research. There are 5 themes that favor passive investment:
- High stock correlation – all stocks rising or falling at the same time present a difficult environment for active management, because there is no differentiation between stocks
- Low stock dispersion – small average difference of performance between individual stocks and their benchmark creates a challenge for active managers, because the amount of reward for good stock selection is muted
- Bull markets – tend to lead to high stock correlation and low stock dispersion
- Large cap outperforming small cap
- U.S. equities outperforming international equity markets
It’s likely no one would argue against the statement that we have been in a bull market since 2009. We can see that large cap has outperformed small in many years, and domestic equities have outperformed international equities. However, it is more difficult to see and understand the relationship between stocks, so let’s take some time to flesh out the correlation and dispersion of stocks, now and historically.
High stock correlation
The chart below captures the correlation effect of stocks. We can see that, most recently, in the post-crisis period, stock correlation has been driven significantly higher and remains well above historic norms. Before this recent period, you can see that stock correlation much above that 50ish percent level is almost non-existent. So, we have had a prolonged period of high correlation. We can look back into the early 90s, when active management tended to have a fairly successful run and, after the tech bubble burst, stock correlation was quite low. This is a way of characterizing a market characteristic that has not really existed for the better part of 7 years or so.
Low stock dispersion
After the tech bubble burst in the early 90s, as well as right around the financial crisis, we saw periods where stock dispersion was high. Stock dispersion has been quite low in the post-crisis period. Obviously, there are events (like earnings releases) that create a little bit of variation, but, broadly speaking and relative to history, stock dispersion has been low, and that has been a headwind for active management.
Why has passive been favored?
We believe this phenomenon is largely driven by monetary policy on a global basis, which has created a macro point of view where investors tend to be simply either “risk on” or “risk off” – they are either in the market or out. They are not differentiating between the stocks or even the sectors that they own. That type of market psychology tends to favor the largest, most liquid market, which is currently the U.S. large cap market.
Hope for active management
We have identified 5 factors that have driven relative performance, all of which speak to this theme that the market is being narrowly led. There is not a lot of discrimination between stocks and the fundamentals that drive them. We think this dynamic is poised to change and we think many, if not all, of these characteristics will be reversing themselves.
We talked about low stock correlation and how higher stock dispersion may be driven by fairly aggressive monetary policy and regulatory reform. The Federal Reserve is starting to normalize interest rates and monetary policy should start to change some of these dynamics. Market leadership should expand beyond just U.S. large-cap markets. The market has been more likely to punish complacency and reward stock selection.
We believe that there is a strong case for active management working in the near future. In other words, we think active management plays an important role in every asset class – so now might not be the best time to jump on the passive bandwagon.