by Greg Meier, Allianz Global Investors
In 2016, over $500 billion moved into passively managed index funds, while $340 billion exited actively managed funds. While this points to a challenging time for active managers, Greg Meier says the shift to passive is misguided for three key reasons.
- During the tech-market bust and great financial crisis, US large-cap active managers outperformed their passive peers.
- Passive investors expect to be able to shift positions quickly, but volatile markets don't always offer enough liquidity to trade efficiently.
- Central bank asset-purchase programs resulted in market distortions that inordinately benefited passive strategies – and they won't last forever.
It is well-known that the active management industry has recently encountered its share of challenges. In the US in 2016, $500 billion moved into passively managed index funds, while $340 billion exited actively managed funds. Yet it is our belief that this shift – while notable – is misguided for three key reasons.
1. Over a full cycle, active managers have done well
First, the fair evaluation of an investment strategy should cover a full market cycle. A 2012 study from Robert Baird shows that while 59% of managers added value over one year, a full 73% did when measured over a five-year period. This carries particular resonance today because of how abnormally long the current cycle has become: The S&P 500 Index hasn't seen a bear market since the financial crisis ended more than eight years ago. To put that into context, the recovery from the Great Recession – the worst in 80 years – equates to the third-longest US expansion and second-longest S&P 500 bull run ever.
This means that since the market troughed in March 2009, the rising tide that has lifted risky assets has simultaneously diminished the need for downside protection – an area where active managers have demonstrated expertise. In fact, during the 2000-2002 tech-market bust and the 2008-2009 financial crisis, US large-cap active managers outperformed their passive peers by 471 basis points and 100 basis points, respectively – and they did so in one of the most competitive markets in the world.
We firmly believe that analyzing corporate fundamentals helps active managers see and navigate storms as they darken the horizon – before they strike. Active managers can benefit from volatility by underweighting underperforming assets, or by simply moving money into cash. When markets get rocky, passive vehicles not only own the entire downside of the index being tracked, but they underperform the index's losses after accounting for fees.
2. Liquidity issues can make passive strategies 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 was the “flash crash” on August 24, 2015, when the Dow Jones Industrial Average briefly plunged nearly 1,000 points.
Circuit breakers (trading halts) were triggered almost 1,300 times, and prices of some popular exchange traded funds (ETFs) disconnected from their underlying assets. For instance, a $2.5 billion US consumer staples ETF lost 32% of its value while the companies in the fund were down only 9%. Clearly, poorly timed trades in vehicles that investors mistakenly think are highly liquid can result in outsize losses.
3. Passive investing benefits from central bank stimulus, which is starting to normalize
Passive managers have benefited from unprecedented monetary stimulus from central banks. Since the financial crisis, all of the major central banks have lowered interest rates to record-low or even negative territory. They have also launched asset-purchase programs such as "quantitative easing" that have distorted the fundamental process of price discovery.
This tsunami of stimulus has buoyed capital markets in general, pushing up cross-asset correlations. The reason this is important is because when correlations are low, stocks should trade based more upon company-specific characteristics. When correlations are high, corporate fundamentals – and the work active managers do sifting through balance sheets, income statements, pay-out ratios and more – goes out the window.
From this standpoint, it is encouraging to see central banks either normalizing monetary policy or considering it. With US labor conditions strong and inflation slowly firming, the Federal Reserve is raising interest rates and plotting to reduce its balance sheet. For their part, European Central Bank officials are discussing tapering QE. Even the Bank of Japan is buying fewer assets through its "yield curve control" program.
Reduced monetary accommodation is a natural part of the economic cycle. As it takes effect, it should dampen cross-asset correlations, further illuminating the need to get and stay active.
Source: FactSet, AllianzGI Economics & Strategy; as at 31 May 2017.
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