By: Bill Martin
Senior Managing Director And Investment Strategist
Active investing is under siege by a proliferation of passive investments. Must there be only one winner in this fight?
In last month’s edition of Cutting Through the Noise, we took a good look under the hood of passive investment vehicles, and concluded that, while they have a number of positive attributes such as low cost, broad based market exposure, and tax efficiency, there are also growing and often unseen potential perils that should not be ignored.
In this month’s blog, we are going to examine some of the positive attributes of active management, and illustrate why continuing to tactically allocate to certain active managers in concert with passive investments, is a sound investment strategy, particularly in light of where the market is currently trading.
Specifically, we are going to cover how:
- It still makes sense to use passive investment vehicles for exposure to efficient and liquid markets, such as Large Cap equities, but
- There are market segments such as Fixed Income, Small Cap equities, emerging markets and certain style sectors, where boutique active managers tend to outperform passive investments, particularly late in a market cycle, and
- Newly emerging “smart-beta” funds are helping to bridge the gap between passive and active management, and merit consideration in the construction of a balanced, all-weather portfolio.
Let’s take the first jab…
Active Vs. Passive Equities: Judges’ Decision, Not A Knock-Out
Active management has been the undisputed champion of the mutual fund world for decades. However, that title belt has been challenged in the past few years by the unprecedented asset flows from active to passive funds. In fact, the estimated asset split in domestic equity funds is expected to weigh in at roughly a 50%/50% split by the end of 2017. This is setting up as a real heavy weight fight for assets going forward. Let’s go ringside…
In this corner, wearing the white trunks – When coupled with their recent stretch of out-performance relative to active asset managers, passive funds have taken on an almost mythical, ubiquitous and omnipotent aura – taking money from active managers in all sectors. However, as we discussed in depth last month, the self-fulfilling nature of money shifting from active to passive investments has led to a massive, momentum-driven bubble building behind the larger index names that are creating crowded trades with the potential to dwarf the necessary price discovery elements of active management. All of this could ultimately lead to more volatility, less liquidity, and market dislocation.
And in this corner, wearing the dark trunks – Although active managers have taken quite a few punches losing asset flows to passive investment vehicles, don’t count them out just yet. This month, we look to provide a head to head comparison between active and passive funds within the equity and Fixed Income asset classes separately, with the intention of leaving you with a better understanding of how and where to find the best investment options within each market segment.
Oh My… What do we have here? It looks like Vanguard, the indexing powerhouse and proselytizer, admits that active investment management deserves to have a dog in this fight. It appears that Vanguard is getting set to roll out a fund line-up of actively managed ETF funds. Interesting.
A more fitting segue does not exist to compare historical performance of active vs. passive investment choices.
Let’s take an empirical look at how active managers have performed relative to indexes in the core space through time.
The green line represents the performance of active managers against their benchmark index. The flat yellow line represents the average number of times when the index beat active managers, measured over a 25 year time period. When the green line dips below the yellow line, active managers are outperforming the index, and vice versa. Hence, from the perspective of active managers, the higher the solid green line the worse they performed relative to their benchmark. In general, Small Cap active managers have slightly outperformed their benchmarks throughout time, while active managers in Large Cap space have moderately underperformed over this period, NET of fees. This has not been the passive fund knock-out of active managers many may have expected.
These charts tell us two very important things:
- Active managers outperform their indexes a greater percentage of time in less efficient market segments. This is evidenced by the fact that Large Cap active managers only outperformed their benchmark 45% of the time, whereas Small Cap active managers outperformed by 55%, and
- Active managers tend to out-perform late in a cycle and well into a recession. This is indicated by the dark shaded areas on the chart where you see the green line drop precipitously and stay low until the end of the recessionary period, indicating a prolonged period of active management out-performance.
This merits careful consideration, as we believe we could be nearing the point where the market could turn south due to fears of increased interest rates or an outright recession. If that is indeed where we are in the market cycle, rotating active managers into the allocation makes a lot of sense.
Boutique Managers Punch Above Their Weight Class
“… boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.”
Let’s narrow this discussion from active vs. passive funds and focus more acutely on the active “boutique manager” sub-group. A boutique firm is one where the portfolio manager (“PM”):
- Has a major equity stake in the firm, often with their name on the door
- Specializes in a specific type of investment
- Does not try to cover all bases and style boxes
- Has the freedom to go where the markets dictate in search of value
- Isn’t subject to the tyranny of sales incentives that can unduly influence strategy
- Doesn’t not get moved off of funds to more profitable funds, after proving themselves
- Is heavily invested alongside shareholders, and
- Is more interested in raising returns than assets.
With boutique managers, the incentive structure outlined above drives long-term, multi-generational out-performance. The ownership structure available at many boutique firms encourages an entrepreneurial risk-taking environment built around an investment-centric franchise. This is key because it keeps good PMs in place and removes the allure for them to leave for greener pastures following short-term underperformance.
The AMG chart below graphically displays some of the benefits/characteristics of the boutique asset management structure.
Of course, all these positive attributes are meaningless if they don’t lead to superior performance. The “Figure 9: Boutique Excess Returns:” chart below provides evidence that boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.
“When utilizing active managers for the Large Cap space, we lean toward managers that can ‘go anywhere’ and are not confined to a particular ‘style box’ market segment.”
This chart highlights that boutique managers generated out-performance over their stated benchmarks to the tune of 141 bps per year, on average, between 1994-2014. Indeed, these numbers are even greater when one looks beyond the US Large/Mid Cap market segment. This is not a surprise. It has long been contended that Large Cap companies are over-followed by analysts, which creates a very efficient market with less opportunity to outperform due to almost complete information parity.
As such, the richest out-performance opportunities tend to lie near the market sectors with the most dispersion and least correlation. This leads us to look to areas like Small Cap and international (especially emerging markets) when looking for active managers.
When utilizing active managers for the Large Cap space, we lean toward managers that can “go anywhere” and are not confined to a particular “style box” market segment. These types of managers can be paired with index funds in the Large Cap space to smooth the ride for one’s investment portfolio, particularly through a down-cycle. Examples of this type of manager include Peter Lynch, Warren Buffet, Bill Miller, and Sir John Templeton. They are all managers that may call themselves “value” shoppers, but are bold enough to skate to where the puck is going to be (or which way the jaw is turning), as opposed to where it has been.
The boutique structure (yes, Peter Lynch was early enough at Fidelity that his Magellan fund was treated as an autonomous boutique fund) gives latitude for Buffet to buy Coke as a Value stock in the 1970’s, because he believed the intrinsic value of the brand was not yet appreciated by the market. He was right. The same happened for Bill Miller’s AOL play and other tech names in the 1990’s, and Peter Lynch’s financial and consumer stocks in the 1980’s. Sir John was early to identify rapidly growing emerging markets as great values in the international markets. Good managers just buy good companies and don’t worry about fitting them into a style box or sales deck narrative.
“Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.”
The next chart shows the enormous payoff that can occur when one is willing to look under the hood to find a good manager and veer away from the risk-averse managers typically found at larger mutual fund complexes. The 20 year numbers below are telling in the extreme. The top-decile boutique manager has beaten their benchmark after fees by over 1100 bps per year! In fact, simply using a top quartile manager led to more than 700 bps of out-performance over the illustrated period.
Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’. This is the market risk we discussed last month, which stems from ever increasing flows into passive strategies that are creating crowded trades, driving asset prices up beyond where they likely should be, and setting the stage for a wicked reversal.
Passive vs. Active Funds: Heavyweight Vs. Middleweight
When we turn our attention from actively managed equity strategies to actively managed Fixed Income strategies, we see marked out-performance by active Fixed Income managers. This is primarily because passive Fixed Income vehicles:
- Allocate a disproportionate amount to the largest debt issuers, which are currently all US Government securities, and they have abysmal yields at present and can lead to a lack of diversification
- Increase interest rate sensitivity because of heavy allocation to Treasuries
- Are forced to sell high quality performing bonds when changes to the underlying index are made that mean the fund’s holdings no longer meet the index’s inclusion criteria
- Usually this type of planned selling results in the worst possible trade execution and pricing on that day as a larger than normal sell volume hammers down bid prices.
Below, we see that the median active Fixed Income manager has out-performed passive investments, such as ETFs and index funds (net of fees) over almost every time period (1, 3, 5 & 7 year returns), as illustrated by 100% of the red dots being above the horizontal line marked 50. While the 10-year red dot appears to the left of the vertical 50, demonstrating under-performance vs. the underlying index, it still appears solidly above the horizontal “peer group” line, indicating better 10-year performance than the ETFs and index funds, net of fees.
“Yes, the passive investments can actually be more expensive than some of their active counterparts.”
This is an important point… ETFs and index funds appearing in many of the higher risk segments of the market (such as high yield), have such high fees and costs that they are uncompetitive with active funds and their underlying indexes. Let that one sink in for a moment. Yes, the passive investments can actually be more expensive than some of their active counterparts.
“Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.”
The chart that follows highlights the challenges that occur within the ETF market once providers move outside highly liquid market sectors. What you see is how certain high yield bond ETFs performed compared to their underlying indexes, after all expenses and fees. Not that great. On average, the ETFs under-performed across the spectrum by over -2% per year.
It is important to highlight that the opportunities for out-performance by active managers in the Fixed Income world only increase as an investor steps out of the risk curve or finds a solid, unconstrained, boutique bond manager to handle the bulk of the Fixed Income portion of their portfolio.
Lastly, the two charts below graphically display the challenges that the high yield bond ETF market will face when flows ultimately reverse. Also, while the liquidity problems are the most pronounced in the high yield bond market, the lack of liquidity impacts all ETF markets (stocks and bonds) globally to some extent, outside of large cap stock and U.S government bond index based funds.
With that caveat out of the way, what the two graphs below display is that while money has poured into the high yield ETF bond market, the counterparties (“dealers”) that actually provide liquidity when someone sells their ETF shares, have backed away. In fact, it appears they are climbing out of the ring. This results in the systemic erosion of the indispensable function that the active market plays in price discovery and liquidity, which we discussed in last month’s blog. The chart on the right is the most striking example of how the ETF craze has impacted this very important function. As dealer inventories decline from above 12% to below 1%, trading volume thins considerably. It will be interesting to watch what happens when panic grips the market and everyone wants their money back at approximately the same time. Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.
There May Be a New Contender Entering the Ring: Smart Beta Funds
In the last few years, a new type of investment vehicle called “Smart Beta” has gained in popularity and aims to blend the best aspects of passive and active management. Smart Beta funds are ETF’s that passively track an index, but instead of allocating the underlying positions according to market capitalization alone, they are weighted according to various other factors such as a company’s dividends, free cash flow, earnings, or volatility. Smart Beta is designed to take advantage of the tax and cost efficiencies of passive investments, but select the underlying investments included in the ETF based on a stated qualitative and quantitative characteristics and data points.
In the Bloomberg chart below, we can see a traditional market cap weighted S&P 500 ETF (SPXT), compared to a Smart Beta S&P 500 ETF (SPXQUT) who’s selection criteria is based upon earnings quality, predictability, sustainability, and balance sheet strength. The results are stunning. One can’t help but think of Buffet’s claim that he would rather buy a wonderful company at a fair price than a decent company at a cheap price when viewing the performance of SPXQUT.
However, as compelling as Smart Beta funds can be, investors must pay particular attention to each fund’s ranking/weighting methodology. Most Smart Beta funds, once the qualitative overlay has been applied, still rank asset weights based on market cap weights, thus making these funds more like the underlying S&P 500 index than the characteristic they are trying to exploit. We prefer a more equal weighting format when considering Smart Beta funds (as displayed by ticker SPXQUT in the Bloomberg slide above), which more acutely focuses on getting the pure Smart Beta characteristics into the portfolio in a targeted fashion.
This is but one example of many different types of Smart Beta portfolios. Baskets of these types of examples can be utilized to shape a portfolio’s contour through an economic cycle. Smart Beta helps achieve exactly this, but in a cost effective, diversified manner.
“It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.”
And Now, The Judge’s Card
Think about this…if we are indeed coming out of a period of orchestrated, Central Bank led, artificially suppressed interest rates, coincident with historically low volatility – do you necessarily want all your money in investments/funds (passive, for the most part) that have most acutely benefitted from those policies. Or, would you prefer to take some of the profits off the table, and prepare for what should prove to be a different environment as the Central Banks look to drain their own swamp of excess reserves?
We may be about to enter a new round in the fight for returns, where the recent past will not be a prologue. It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.
Bottom line, a good active, boutique manager (top 1/3) will significantly beat an index through a full market cycle, particularly on a risk-adjusted basis in a lesser efficient market sector. The difficulty lies in finding those good managers. The answer is not to buy a manager that has only recently out-performed, but rather to pick a manager with a good long-term track record, who may have only recently fallen out of favor, but is very likely to recover and continue along the same successful long term trajectory.
Focus your manager search on the boutique arena, particularly within more illiquid and less efficient market segments, and lean towards active management for the Fixed Income portion of your portfolio. Doing so will help ensure your investment plan “floats like a butterfly and stings like a bee” through the full market cycle.