Back into the active/passive trenches

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Institutional Investor, September 12, 2023:

It’s Official: Active Management Is Back

After an exceptional bull market that lasted more than a decade, volatility and higher interest rates set the stage for the return of active management and stockpicking investors were ready for the spotlight.

Out of 8,212 funds with approximately $17 trillion in assets (about 55.9 percent of the U.S. fund market), 57 percent of actively managed mutual funds and ETFs survived and beat their average passive counterpart over the 12 months through June, according to Morningstar’s semiannual Active/Passive Barometer report. That was many more actively managed funds than the 2022 calendar year, when only 43 percent were successful.

S&P Dow Jones Indices, September 21, 2023:

Look, the Morningstar report that Institutional Investor cites is as legit as the SPIVA scorecard from S&P DJI. We don’t doubt the numbers there, even if the methodology is subtly different (and the SPIVA numbers are for the first half of 2023, rather than the 12-months to end-June that Morningstar used).

And there can (in theory) be years where a majority of active managers do outperform — eg 2005, 2007 and 2009, as the SPIVA chart above shows.

These days, equity mutual funds are only a fraction of the overall stock market, so they can outperform as a group without violating Bill Sharpe’s arithmetic of active management.

But for the love of God, can we stop running headlines about active management being back on the rare occasions that a short-term arbitrary snapshot of time shows that they have done a bit less badly than usual?

In theory, it should be a better time for stockpicking when correlations are low and dispersion is high. The first means that equities don’t move as much in lock-stop, increasing the opportunities for active management; and the second means that the difference between good and bad stocks is elevated, enhancing the rewards for active managers that get it right.

But in practice, there seems to be little, well, correlation between low correlations/high dispersion environments and active management performance.

To be fair to stockpickers, although the environment looks superficially decent for active managers right now, the muted correlations and decent dispersion is mostly driven by the humongous gains for the biggest (often AI-adjacent) stocks.

That makes things tricky for active managers, as going overweight on already-massive index members is difficult and risky. As S&P DJI puts it in today’s mid-year update:

The relatively weak performance of the largest stocks helped to explain the comparatively good performance of active managers in 2022, just as their relatively strong performance in early 2023 served as a headwind.

That’s one of the reasons 52 per cent of mid-cap managers have outperformed their benchmarks in 2023, and a thumping 72 per cent of small-cap specialists.

However, as we’ve written before, the stock market’s characteristics are constantly changing, and the investment styles that work go up and down in tandem, but it doesn’t really change the fact that in the longer run, the results of active management are not good.

Here’s a chart looking at the waning outperformance of all 39 different categories that S&P DJI tracks — across both equities and fixed income. After 15 years there are no categories where a majority of active managers beat their benchmarks.

But we are already girding ourselves for predictions that 2024 will be the year when active management stages its comeback.