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Active investing has grown stronger recently, but can this last?

INSIGHT ARTICLE  | 

For much of the past decade, equity markets enjoyed a bull market that was accompanied by the rise in popularity and outperformance of passive investment strategies. Investors were attracted to their low fees and were persuaded by the argument that active managers could not consistently beat the market.

Indeed, in the second half of last year, assets in passively managed equity exchange traded funds and mutual funds for the first time surpassed those of actively managed funds.

Then the coronavirus hit. As markets plunged in March, the case for actively managed investments grew stronger as those funds performed better than passively managed funds—even if the trend toward capital flowing into passively managed funds and ETFs remained largely intact.

While both active and passive strategies suffered steep drops from the end of February to the end of March, passively managed funds experienced a bigger drop, which has changed the return profile over the past few years in favor of actively managed funds.

Historically, active management fares better when financial markets are volatile and there is wide price dispersion among financial assets. These periods present opportunities for skilled stock pickers, and actively managed hedging strategies can protect investors from a significant downturn in security prices. When price movements are dispersed, professional managers demonstrate their skill by picking the best stocks to buy or offload and shifting portfolio asset allocations to suit prevailing market conditions.

But for years, this kind of volatility was mostly absent from the equity markets. Except for a few periods like the euro debt crisis of 2011, the long bull market that ended with the onset of the coronavirus was characterized by low volatility and high correlation among securities—an ideal environment for most passive strategies to be successful.

In such conditions, security prices can rise indiscriminately which makes it difficult to justify the cost of active management when investment in index funds or other passively managed baskets of securities—at a fraction of the cost—can yield attractive returns.

The strong stock market rebound since the end of March has shown that the performance of active investing versus passive investing is cyclical and can shift as market conditions change. A comparison of the two strategies in the month of June or for the past quarter, which has been characterized by much lower levels of volatility relative to the extemely elevated conditions in March, shows passive management already making a comeback.

Price dispersion has also dissipated over the same period. During the initial phase of the current stock market recovery, defensive and technology stocks outperformed the market. As markets continued to rally through April and May, market confidence grew and investors started wading into financial and other growth stocks.

Until recently, when the Fed quelled market sentiment by communicating a more dire economic forecast that dampened expectations for a speedy recovery, some distressed stocks had also started seeing strong price gains. This return to a broad-based rise in stock prices, should it continue, may bring about another inflexion point between active and passive investing.

So far, the resurgence in the performance of active management has not slowed the flow of funds into passively managed funds. It will take a much longer cycle before there is a reversal in capital flows in favor of active strategies. The low fees associated with passively managed funds, the allure of the returns they have generated during the good times and the fledgling recovery since late March should continue to attract more capital into passively managed ETFs and mutual funds.

The takeaway

The debate between active investing and passive investing seems set to continue. As sure as market conditions will change over time, the cyclical shifts in the performance between active investing and passive investment may continue to be a feature of financial markets. But for the time being, capital flows should continue to favor passively managed funds, despite some periods of underperformance compared to actively managed funds.

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