Three reasons to get active

Over a full cycle, active managers have done well

First, the fair evaluation of any investment strategy should cover a full market cycle. A 2012 study from Robert Baird shows that while 59 per cent of active managers added value over one year, 73 per cent did so over five-year periods. This carries particular resonance today because of how abnormally long the current market cycle has become: Despite the recent sell-off, the S&P 500 Index hasn’t seen a bear market since the financial crisis ended more than nine years ago.

This means that since the market troughed in March 2009, one key area where active managers have proven expertise – providing downside protection – has been in less demand because of the rising tide that lifted most risky assets simultaneously.

Yet when the markets have not performed as well – such as during the 2000-2002 tech-market bust and the 2008-2009 financial crisis – our research shows that US large-cap active managers outperformed their passive peers by 471 basis points and 100 basis points, respectively.

One of the tools that helps active managers navigate storms before they strike is their ability to analyse corporate fundamentals of the securities they own. When volatility rises, active managers can underweight underperforming assets, or they can simply move money into cash. Passive vehicles, on the other hand, are at a disadvantage when markets get rocky: they not only fall in lockstep with the index being tracked, but there is a risk they will underperform after accounting for fees.

Poor understanding of passive strategies can be problematic

Second, the shift toward passive is troubling because of how passive instruments are deployed. Frequently, passive investors buy index funds for tactical rather than strategic reasons, meaning they expect to move in and out of positions quickly. But when markets get volatile, there isn’t always enough liquidity to trade efficiently.

A prime example of this problem can be seen in the “flash crash” of 24 August 2015, when the Dow Jones Industrial Average briefly plunged nearly 1,000 points. Circuit breakers (trading halts) were triggered almost 1,300 times, and the prices of some popular exchange traded funds (ETFs) disconnected from their underlying assets. One US consumer staples ETF lost 32 per cent of its value even though the companies it owned were down only 9 per cent.

These types of trading risks may extend well-beyond “plain-vanilla” equity ETFs. According to a March 2018 Wall Street Journal article, some popular bond ETFs have grown more attractive to short-sellers due to questions about the funds’ ability to process redemptions when markets turn.

When investing in passive instruments, it is vital to look beyond the focus on low-cost fees and tactical trading to understand the intrinsic characteristics of these products. Take volatility ETFs, for example. Long-volatility ETFs are designed to lose money if held over the long-run because they must constantly buy expensive longer-dated options contracts while selling less-expensive shorter-dated contracts.

And while short-volatility ETFs can benefit from the same dynamic, their investors can get wiped out when volatility spikes. In fact, many “new-era” passive investment products – for instance, active ETFs and smart-beta ETFs – have neither an extensive track record nor a broad asset base. This means they may not behave as expected when market conditions shift.

If recent experience tells us anything about passive investing, it is that understanding your investment is critical. Poorly timed tactical trades in supposedly highly liquid vehicles may result in outsize losses.

Passive investing benefited from central-bank stimulus, which is now unwinding

Third, passive managers have benefited from years of unprecedented monetary stimulus from central banks. After the last financial crisis, the world’s major central banks lowered interest rates to record-low, sometimes even negative territory. They also launched asset-purchase programs such as “quantitative easing” that stimulated markets even more. These efforts pushed up asset classes’ correlations – the tendency to move in lockstep with one another.

The reason this is important is that when correlations are low, stocks tend to rise or fall based on their company-specific characteristics. Corporate fundamentals and the valuable work that active managers do – sifting through balance sheets, income statements, pay-out ratios and more – have the potential to make a real difference. But when correlations are high, stocks tend to go up and down at the same time.

From this standpoint, it is encouraging to see correlations returning to normal as major central banks normalize monetary policy – a natural part of the economic cycle. The Federal Reserve is raising interest rates and unwinding its balance sheet, European Central Bank officials are tapering QE and the Bank of Japan is buying fewer assets through its “yield curve control” programme.

We think their combined efforts mean global central-bank liquidity could reach its peak in 2018 and correlations are likely to continue falling – one more reason for investors to get, and stay, active.