May 1, 2020

The Debate Goes On: Active vs Passive

by Tom Roseen.

The perennial debate over passively versus actively managed funds continues. Historically, both camps have offered sound reasoning for embracing one investment practice over the other. But they both might be right.

Relative Performance: Active vs Passive

On one hand, the argument goes, investors benefit from the low expense ratios and low portfolio turnover of passively managed funds, which bring passively managed mutual funds’ and ETFs’ total returns very close to their index benchmarks. However, in about 84% of the relative performance observations (fund return minus the benchmark return), passively managed funds underperformed their benchmarks after taking expenses and cash drag into account, with a median excess loss/underperformance of their benchmark of just 51 basis points (bps) for 2019. For the remaining 16% of the relative performance observations, the median excess gain/outperformance of their benchmarks was 41 bps for 2019.

On the other hand, while actively managed funds are often cited as having a difficult time outperforming their benchmark because of higher relative expense and portfolio turnover ratios, we note that actively managed funds have a higher likelihood of outperforming their benchmark than their passively managed cohorts. About 43% of actively managed funds beat their benchmarks in 2019, with a median excess gain/outperformance of their benchmarks of 225 bps. For the remaining 57% of relative performance observations, actively managed funds underperformed their benchmark by 296 bps.

What were the actual returns?

When the market is firing on all cylinders, it makes sense that it becomes more difficult for an actively managed fund to consistently outperform its benchmark (a rising tide lifts all boats), requiring the active manager to add enough alpha to compensate for the fund’s higher relative expenses and cash drag (those dollar amounts set aside by a fund to meet redemptions and new money flowing in that have yet to be put to work in the portfolio and thus not benefitting from the upward market trend).

However, during turbulent times, actively managed funds benefit from the ability to allocate assets away from troubled sectors/securities and over to winning sectors/securities, while their passively managed brethren must follow the allocation of the benchmark index.

For Q1 2020, we see that during the recent market meltdown actively managed equity funds were able to mitigate losses better than passively managed equity funds and ETFs. However, the same cannot be said for the fixed income universe, where passively managed funds mitigated losses better than their actively managed counterparts which, in search of yield, probably put on relatively more risk than their benchmark.

What do fund flows show?

For Q1 2020, passively managed funds (including ETFs) outdrew their actively managed fund counterparts, attracting $61.6 billion versus handing back $303.3 billion, respectively. As has been the case, actively managed domestic equity funds (-$105.1 billion) suffered the largest net redemptions of Lipper’s equity related macro-groups during the quarter while their passively managed domestic equity fund cohorts attracted $66.3 billion. However, these numbers don’t confirm the one-to-one shift from active to passive as many pundits have claimed.

For example, looking at U.S. large-cap funds, we see that over each year since the 2000 technology meltdown—aka the dot-com bubble—investors began to embrace passively managed large-cap funds over their actively managed cohorts. This happened to a lesser extent, however, than outflows from the latter show. Large-cap funds (including passive and active funds) make up about 10.4% of the U.S. open-end mutual fund universe, accounting for $2.356 trillion of the $22.721 trillion in total assets under management as of March 31, 2020.

I argue that much of the net redemptions away from large-cap funds is a thoughtful reallocation by Baby Boomers from their primary core large-cap holdings in their core-and-satellite accumulation model to other underinvested asset classes, such as taxable fixed income funds, municipal bond funds, sector equity funds, alternative funds, commodities funds, and real estate funds, rather than just a move to passively managed vehicles.

Where do we go from here?

For years we have shown that investors have added incremental returns to their portfolios by using a combination of actively and passively managed funds. During periods of strong upward moves in the market, passively managed funds have had an advantage over actively managed funds, while during periods of increased volatility and sector rotation, actively managed funds have edged out their passively managed brethren.

In a related segment released in 2009, our then Chief Index Strategist Andrew Clark, said, “Since there are periods when one type of fund outperforms the other, allocating a portfolio between actively managed and passively managed funds has been shown to provide additional returns to investors willing to accept additional transaction fees and possible larger drawdowns.” However, he also suggested that the purely do-it-yourself long-term buy-and-hold investor might be better served by focusing on passively managed funds.

The debate will continue between actively managed and passively managed fund proponents. But the bottom line for individual investors and advisors alike is their need to maximize returns while minimizing risk. Perhaps by allocating and periodically rebalancing our limited resources to both passively and actively managed products, we will be able to reap the benefits of both worlds over the long haul.

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