Revisiting Active US Equity Management: A Cyclical Story by Cambridge Associates
What a glorious time to be a US equity investor! Markets have charged ahead nearly uninterrupted for several years—the S&P 500 and Nasdaq are hitting new highs; the momentum looks like it will go on forever; and who needs active managers that can’t keep up with passive indexes, where everyone is piling in? It will be exciting to see what the new millennium brings as we sit here in 1999! Oh, you thought we were discussing 2015? In fact, the parallels between the conversations today on the futility of active management in US equities and those in the great bull market of the late 1990s are striking.
It’s hard to argue with the benefits of index investing when a rising market tide is lifting all boats, and the clear movement over time toward index investing makes sense for many investors. We are not unconditional advocates for or against active management; investors have different circumstances. However, while there are many logical rationales for favoring index over active investing, the recent performance struggle of the average active manager is not among them. The investment industry and the press love to make absolute claims in the active versus passive debate, and the volume of rhetoric from either side seems to grow loudest near cyclical peaks and troughs. The result is yet
another behavioral force tempting investors to abandon their long-term plan to chase what has worked recently. Our aim is to provide a longer-term perspective to remind investors that neither side of this debate succeeds or fails in a straight line. The lesson that everything has its time and place is important to periodically (re)learn.
A Look at the Data on Active US Large-Cap Manager Trends
Earlier this year we published our annual analysis of active US equity managers,1 which showed the median manager in our US equity ex small cap universe has underperformed for four of the last five years and five out of the last ten. To some the takeaway is clear: the odds are 50:50 and active managers aren’t worth it. However, keen observers will notice that while passive won in four of the last five years, active won in four of the prior five. A longer-term look at market history indicates that this kind of trend regularly (and cyclically) occurs. When viewed from the perspective of rolling period returns, periods of tailwinds and periods of headwinds are both apparent. These cyclical trends in performance are not just a symptom of movement in cyclical favoritism between investing styles. Both growth and value managers see headwinds and tailwinds. Many cite bear markets as periods that favor active approaches. Our analysis suggests this is a fair statement, and the US equity market hasn’t had one of those in a while. How managers do in a bear market depends on the type that occurs. Narrow-based corrections, such as the 2000–02 bear market that was driven primarily by the technology and telecommunications sectors, provide more room for active managers to position against the retreating tide, whereas broad-based downturns, such as the 2008 downturn, provide few areas for safety.
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Investor sentiment and flows tend to follow performance. Some of the current favor toward index investing is likely driven by active managers’ aggregate recent underperformance. Based on data from the Investment Company Institute, index equity mutual funds’ share of total equity mutual funds’ net assets was 20.2% at the end of 2014, nearly double the 11.6% market share from a decade ago. At the same time, active US equity managers have seen fairly persistent negative asset flows since 2005, though it’s challenging to determine where this outflow is moving. Is it swapping for passive or going into strategies outside the United States, fixed income, or other asset classes? Regardless, the data suggest interest in US index strategies2 is growing at the expense of active strategies, and investor sentiment can be an interesting contrarian indicator, as shown in the chart on the next page, which uses net flows to passive mutual funds and exchange traded funds (ETFs) as a proxy for investor enthusiasm for index strategies (or market beta). Flows to index strategies swell as a bull market gains steam, and active managers tend to outperform during market corrections.
Structural Biases Can Be Catalysts for Cyclical Shifts in the Debate
Both active and index portfolios come with embedded structural biases that can help explain past results and also frame future expectations. On the active manager side, US large-cap managers have historically exhibited a persistent smaller-cap bias and some tendency to hold stocks outside their index (for example, allocations to non-US stocks). In addition, managers’ cash positions will impact performance relative to cashless indexes. Of note, while these biases are persistent at the average or aggregate level, they are under the control of individual managers, so their degree of impact on any given manager will vary. Perhaps bear markets favor active managers as a result of active managers’ opportunity to overcome the structural biases inherent in market-cap-weighted indexes-namely, their embedded momentum skew, which can be exacerbated by investor flows. This skew comes about as stronger-performing stocks, industries, and/or sectors necessarily become a larger proportion of an index over time. As their respective prices move up, their marginal weight increases, as does their influence on the overall index’s performance. As Grant’s Interest Rate Observer recently quipped, “long bull markets tilt the investment debate in favor of the autopilot approach.”
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