Much has been made on the “death of active investing” due to the investor’s increasing preference for low-cost index funds, made more accessible through the proliferation of ETFs. As the charts below show, there is no denying this trend. Historically, the high costs of active funds have seldom been justified by their performance relative to any relevant benchmark, making them ripe for disruption.
As of: 1/13/17
As of: 12/31/16
It is easy to extrapolate these trends forward and determine that active investing is a thing of the past. However, as efficient market theory is the key tenant to a passive investing strategy, it is important to remember that efficient markets depend on knowledgeable market participants (aka active investors). The normalized balance of active and passive dollars in the market required to maintain efficiency is anyone’s guess, but it is in fact a balance. So, at some point the rout of active management should slow. Perhaps it will take another bear market for some investors to realize that active management has its place and that a few dozen basis points of expense savings may not be worth a few dozen percentage points portfolio decline in a bear market.
Volatility is essentially the opportunity for any investment that tactically strays from a benchmark to perform. Today’s record low volatility seems to further perpetuate investors’ complacency with passive investing. However, might this complacency be creating opportunity for active investors? The chart below shows the spread in 30-day volatility between the average stock in the S&P 500 and the S&P 500 itself. These should move in lockstep, and they do. However, when a few stocks are driving the market or correlations significantly diverge, the spread between them can increase. For active investors looking at different companies, it might be fair to call this spread their opportunity against the benchmark. As you can see, the trend was fairly steady but since 2015 it has risen from just over 10% to nearly 13%. Perhaps active managers are on the verge of a comeback?
Data: Bloomberg Source: Beaumont Capital Management
Furthermore, what might happen if volatility does pick up again? Look at the same chart below when we extend it back to the financial crises. Not only did total market volatility pick up in 2008 and 2009, but active managers theoretically had even more relative opportunity to outperform (or underperform).
Data: Bloomberg Source: Beaumont Capital Management
Passive investing is a great alternative that undoubtedly provides the opportunity for the average investor to experience improved returns. It is always darkest before the dawn, and the question for active investors may simply be “How long is the night?”.
