Why we believe active will trump passive for the next decade
October 31, 2017
Have you heard people bragging about the performance of their passive equity funds? Has it become cocktail party talk? No doubt passive strategies have dominated during the past decade, but I believe their run is about to end. Sure, you could say I’m biased. After all, I’m a small- and mid-cap growth manager, and yes, like many of my peers, I underperformed in 2016.
It hasn’t been an easy time for active managers as they’ve struggled to outperform. As a result, passive strategies have garnered a huge percentage of equity fund flows. Over the past year, active funds experienced more than $150 billion in net outflows while passive saw the exact opposite result, with approximately $670 billion in net inflows (data: Morningstar, for trailing 12 months through Sept. 30, 2017). That’s a staggering amount, and as the old market adage says, when everyone is leaning one way, it’s about to flip, and the fall-off could be nasty.
I know the arguments in favor of passive strategies. To begin with, they certainly take the emotion out of investment management. The reason passive investing has worked during the last 10 years is that we’ve been stuck in such a mediocre macro environment. We live in a post-2008 world in which we’ve seen the end of the consumer debt cycle and are thus contending with an economy that lacks vibrancy. The results have led to a securities market that is more influenced by macroeconomic issues than it is by fundamentals. This, in turn, has led us to a decade in which active management has struggled and passive products have outperformed. We think that’s about to change.
Why? Because active management tends to do better when the economy is more robust, when fundamentals matter more, and when trends can really take hold. When trends are strong and creating value, active managers can identify and overweight those trends and thus increase the likelihood of strong performance. The last time our economy had a strong expansion was in the 1980s and 1990s. During that period, we saw the emergence of global brands as logistics improved, the penetration rate of personal computing went from 0% to 60%, and big-box stores revolutionized merchandizing. Active managers that identified these trends benefited in a big way. During those two decades, approximately three-fourths of small-cap growth funds outperformed the Russell 2000® Growth Index; during the most recent decade, by comparison, this proportion fell to less than half (data: Morningstar, based on the average percentage of mutual funds that outperformed the index on a rolling 3-year basis).
So why will the economy do better now?
Throughout history, investor behavior has swung from fear to greed and back again. We have been living in fear for nearly a decade now. The collapse of the consumer debt cycle and the meltdown in housing markets didn’t just give us a recession, they gave us a long-term behavioral change similar to what was seen in the 1930s and 1970s. Since then, people have been fearful. They have been spending differently. Home ownership levels have fallen to all-time lows. Not only are people spending differently, they are investing differently as well, thus their adoption of passive and alternative solutions. They are also borrowing less, pushing debt service levels to generational lows.
This pessimism or fear can be ingrained for a long time, but it never lasts forever. Eventually, people get tired of being negative. President Trump, and his proposed policies, have proven to be a tipping point for this swing from fear to confidence. I know he won’t pass all of the policies that many are hoping for, but directionally, he is pro-business: “America first,” tax cuts, infrastructure, and deregulation. He wants to get the economy going again. At the end of the day, we have an administration supportive of growth and business.
Simultaneously, consumers are seeing significant wage increases for the first time in a decade, unemployment is low, and confidence has returned. From Main Street to the board room, people are taking action: improving their homes; starting new projects; and investing for the future. This is creating a constructive environment for the economy and thus the equity markets.
We anticipate that the swing toward greed will be slow, but it will likely accelerate over time, allowing for certain trends to really take hold. As pessimism subsides, fundamentals should come back into focus, equity correlations should continue to fall, and we should see a renaissance in active management (or at the very least, an improvement).
Opportunities for active management
Trends that are creating massive opportunities in the environment described above include streaming media, social networking, improved construction techniques, and quality living.
- Streaming media and social networking. These are huge trends with substantial ramifications, and they are changing the way we get our content. My mom still watches cable but my kids are on social media constantly and mostly stream their television. Why? Because these services are quicker, more mobile, and provide content that is highly individualized. This trend is an example of the creative destruction process that makes our economy so great. It’s often driven by better technology, and that is what we are seeing here.
- Quality living. More than ever, people are focused on healthy lifestyles and a better quality of life. As a result, several industries are benefiting including weight management, organic foods, fast casual restaurants, and improved healthcare services. As an example, from restaurants to grocery aisles, people want better quality in what they eat. Sales of organic foods are growing much faster than traditional food categories. All in all, this represents a sea change in how people are choosing to eat.
- Building better cities. Improved and more efficient construction methods and materials are leading to an overhaul of our cities and buildings. The demand for building materials that are more energy efficient is leading to notable opportunities for companies that can provide LED lighting, HVAC systems, and glass/windows, to name a few.
The long, slow swing from fear to confidence has finally begun. A business-friendly administration should help support a stronger economy for years to come. We believe pessimism will dissipate and optimism will gain traction as confidence among consumers and businesses slowly improves. We believe there is strong evidence that new trends are likely to take hold and fundamentals are poised to strengthen — active investors should therefore benefit from these trends.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
The Russell 2000 Growth Index measures the performance of the small-cap growth segment of the US equity universe. It includes those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.
The views expressed represent the Manager's assessment of the market environment as of October 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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Past performance does not guarantee future results.