According to S&P’s SPIVA report, 84.62% of active large cap managers underperformed the S&P 500 Index during the 12-month period ended June 30. Managers in other asset classes have done even worse when compared to their corresponding benchmarks.
Yet, advisors should tread carefully with index investing, in part because the stampede to passive products has created a variety of risks. At the same time, market conditions could change and provide a much needed tailwind for active managers.
Regarding risk, it’s important to note that most indices, including the popular S&P 500, are market cap weighted, so the largest companies represent what some investors believe are a disproportionately large portion of passive funds’ assets. Over time, of course, valuations of those companies can swell, which in turn can make them more susceptible to market downturns.
Indeed, index funds were highly popular during the 1990s, which initially was rational because stocks were cheap. However, over time valuations have increased and when the tech bubble burst, many investors took a beating. Passive funds fell out of favor and an increasing percentage of active managers outperformed their benchmarks.
More recently, active managers have faced a variety of headwinds. For example, many active managers seek out companies with strong fundamentals that have potential to grow their earnings. With unprecedented levels of monetary stimulus, including quantitative easing, bonds yields worldwide have plummeted. This has led income hungry investors to turn to bond-like equities, or equities of companies with little earnings growth potential but steady dividends.
As a result, the types of equities that active managers prefer are out of favor with investors and have been underperforming. Bond-like equities--like bonds--however, are interest rate sensitive. Indeed, in the third quarter, rising interest rates caused bond-like equities to underperform, with the Utilities and Telecommunication Services sectors declining substantially.
If the trend continues, active managers could benefit as growth stocks become more popular among investors and bond-like equities lag. Active managers also tend to favor smaller-cap stocks, which have also been out of favor with yield hungry investors.
Broadly speaking, however, small-cap stocks have low valuations relative to other asset categories, which implies that the stocks may outperform and support the relative performance of active managers.
Regardless of when market conditions change and create better conditions for stock pickers, advisors should consider that a portion of active managers who underperform are considered “closet indexers,” or managers who run portfolios that nearly mimic the indexes. Such funds are likely to underperform due to the manager’s fees.
With that in mind, it may be more accurate to assess the percentage of managers who outperform their benchmarks by looking for stocks pickers with portfolios that have a high active share ranking, which is a measurement of how a portfolio differs from its benchmark. Advisors should also seek out managers with attractive track records and low fees as expenses can be a high hurdle for stock pickers. It may also make sense to consider a hybrid approach that consists of both active and passively managed funds.