Zero percent interest rates and low market volatility are gone and so is the case for passive investing in this new rocky market. Ignore these warnings, say active managers, at the risk of losing a boatload of money in the next lost decade.
These are some of the recent warnings of active managers. In the last decade, passive investing styles have been in ascendant, in part owing to low interest rates and volatility. But AllianceBernstein and Natixis Investment officials, among other active managers, say that passive sweet spot is disappearing.
“Like low rates, low levels of volatility have contributed to consistent investment returns over the past ten years. But as rates rise, many foresee a return to historical norms that make volatility a more significant factor,” according to the 2018 Natixis investment outlook.
“Higher volatility translates to higher dispersion, which works in favor of active managers. But it also tends to create more challenged market conditions. This landscape leaves a lot of space for active managers to add value,” according to Richard Brink, senior vice president and market strategist in the client group for AllianceBernstein.
Active managers would like to fill up a lot more space after the last decade.
Indeed, in 2007, flows into funds using passive styles were slightly ahead of the active fund’s flows: $8.6 trillion to $7.2 trillion, according to Morningstar, which excludes money market funds. But last year, Morningstar said, the passive flows trend accelerated. It had reached $18.1 trillion versus $11.4 for active funds.
However, recent passive investing successes could mislead many advisors and investors, active managers say. The danger, active managers caution, that passive investing could be mesmerized by recent returns and forget about what preceded them at the outset of the century; a decade of investing disaster.
Real returns in U.S. large cap stocks were in the red in the period between the end of 1999 and the end of 2009, recording minus -4.21 percent a year. And U.S. small caps were minus -0.09, according to Thornburg Investment Management.
“The decade from 2000 to 2009 was marked by two bubbles that burst,” Thornburg wrote in a report that emphasized that it is in long term holding periods of 20 to 30 years that investors obtained good returns.
Why is it sometimes a good environment for active investing and sometimes not?
Brink’s AllianceBernstein says the relationship between beta and alpha is what makes the difference in the battle between active and passive styles.
The bigger the beta, the risk of a trade or an investment, the better it is for active managers. The beta of recent markets created few opportunities for active managers to take advantage of mispriced stocks.
“The great rising tides of these markets make individual boats less important—even when they’re better boats,” Brink writes.
However, the connection between alpha, superior performance, and beta, market risk, is volatility. The higher the volatility, the higher the dispersion, “which works in favor of active managers,” Brink adds.
Natixis officials, at a recent news conference, predicted that 2019 will be a good year for active management.
“It will make the case for active management,” according to Andrea DiCenso, a co-portfolio manager for Loomis Sayles, speaking at a recent Natixis news conference.
She is part of a group of investment managers who are once again making the case for active management. They are also warning that, in a protracted bear market, passive investing will result in an investor slaughter.
The new investing norms of the last decade, say critics of passive investing, came out of a period of cheap money and relatively low volatility. Those unique conditions—when for instance central banks were practically giving away money—no longer apply. Central banks are now raising rates.
But despite the stars now seemingly being aligned for active managers, an industry observer says everything isn’t perfect for active management.
Ben Johnson, director of Global ETF research at Morningstar, says the talk of active management making a comeback smacks of market timing, which he warns is moonshine. Johnson has studied active vs. passive performance over decades. Johnson says there are a few instances in which active funds outperform indexes. He says it is usually actively managed funds with low costs that perform well.
Although active managers now say the future is now. Johnson, in Morningstar’s Recent Active/Passive Barometer issue, notes their recent numbers are poor.
“The one-year success rate among active U.S. stock-pickers declined relative to year-end 2017. Just 36% of active managers categorized in one of the nine segments of the U.S. Morningstar Style Box both survived and outperformed their average passive peer over the 12 months through June 2018,” according to the report.
He notes that recently the active managers success rate of beating indexes has been going down.
“Stock-pickers in the large-, mid-, and small-value categories,” the report said, “saw their success rates decline 23, 27, and 27 percentage points, respectively, versus their mid-2017 levels.”
He agrees that greater dispersion gives some active managers a better chance to beat the indexes.
“There are indeed good active managers. But they tend to be far and in between,” he says. Johnson warns that it can be difficult to identify these performers. One might dodge one market crash, burnishing his or her reputation, but then run into another.
So what is the common aspect of these unique active funds?
They charge very low fees, even for active managers, he says. Johnson adds that the Vanguard actively managed funds, such as Vanguard Star and Vanguard Prime Caps, are examples of actively managed funds that “don’t have as many cost hurdles to jump over” as many active funds.
Nevertheless, Johnson ridicules the idea that environment for active investing should lead investors to change their allocations.
“I would say,” Johnson notes, “that the idea of a stock picker’s market belongs in the same category as a man in a big red suit who puts presents under your tree.”
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