By Rusty Vanneman, CFA, CMT, CLS Investments Chief Investment Officer
Active management has had a bad rap in recent years, but I expect the winds are beginning to change and a period of improved relative performance lies ahead. There are five winds to note: Two are heavy headwinds lessening in strength, and three are seasonal headwinds set to become tailwinds.
Defining Active Management
First, what exactly is active management? And, what is all the fuss about “passive versus active” management that generates so many headlines and articles?
In my opinion, there is too much chatter and ink spilled on the “active versus passive” debate and thus a lot of confusion among investors. There are a few topics here rolled into one — the most significant being the move from actively managed mutual funds to ETFs. It’s a complex subject, and I believe understanding can be clearer if we are all on the same page, first regarding how the terms are defined.
Passive management refers to portfolios that aim to match the return of their underlying benchmarks. Success is defined as matching the benchmark’s return (to get a little technical, the fund would have no “tracking error” if the benchmark’s return was matched). That means a passively managed fund that outperforms its underlying benchmark could be a poorly managed fund. The decision-makers on the fund are passive in making judgments about the markets and their future direction and officially have no view on market risks, fundamentals, or valuations. Nearly all passive funds underperform their benchmarks due to expenses.
Related: Strategic Versus Tactical Asset Allocation
An active fund, however, aims to outperform its underlying benchmark. Success is defined as achieving a higher total or risk-adjusted, return over time. Managers make active decisions about where the market presents opportunity. Instead of being like the benchmark, they are trying to be different. While more actively managed funds beat their benchmarks, it is important to note the average actively managed fund has historically underperformed the average passively managed fund in terms of total returns. We will dive into those reasons later.
The next key item to determine when referring to passive or active portfolios is whether the subject is the overall investment portfolio or the underlying holdings of the investment portfolio.
At the overall investor portfolio level, I would argue all investor portfolios are actively managed. There must be some judgement on how a portfolio is allocated based on the investor’s objectives, constraints, investment universe, risk tolerance, and many other unique considerations. To be truly passive, one would simply always own the global market (both stocks and bonds), and that is rarely the case. Thus, being “active” is a good thing for investors. Decisions do need to be made.
The active versus passive debate becomes more significant when reviewing the ingredients or underlying holdings that make up investor portfolios. In this case, active and passive funds are both fair game. Some investors prefer active management; some prefer passive. At CLS Investments, we use both. It just depends on the situation.
In general, active management strategies have underperformed passively managed strategies. While many studies show active professional money managers usually add value — before fees and adjusting for cash holdings — the net return experience for investors has generally favored passively managed funds, especially during the current bull market.
Related: Do Active ETFs Outperform?
Despite this track record, we think active management will perform better in the years ahead in terms of relative performance. There are two ways to measure this.
The more common and less precise measurement considers how all funds (regardless of mandate or underlying benchmark) perform versus the S&P 500 Index. In recent years, the S&P 500, which represents U.S.-based, large-cap, growth-oriented companies, has outperformed nearly every other asset class. Thus, many commentators naively suggested active management wasn’t working. The chart below captures the relative performance of the S&P 500 versus all funds. When the line is going down, the S&P 500 is outperforming. When the line is going up, the S&P is underperforming. I believe this chart is first and foremost about global diversification and secondarily about active management.
However, even when using this definition and measurement, I believe active management is poised to shine in the years ahead. As we have written numerous times, the S&P 500 is now expensive relative to other market indices and asset classes, and given the cyclical nature of the markets, it will likely underperform in the years ahead. When this tide shifts, as it appears it already has, it is likely that:
- international will outperform domestic stocks,
- value will outperform growth,
- small-caps will outperform large-caps,
- smart beta ETFs will outperform market-cap ETFs, and
- active management will outperform passive management.
The second, clearer method of measuring active management’s success considers how active managers are doing versus passive funds within the segment of the market(s) in which they specialize. For example, this method would compare actively managed small-cap funds to passively managed small-cap funds, not the S&P 500.
In this case, I believe actively managed funds will perform relatively better in the current and expected market environment for five reasons. As stated previously, two (1 and 2 below) are headwinds lessening in strength, and three (3-5 below) are seasonal headwinds that should eventually turn into supportive tailwinds.
1. Lower costs
Actively managed funds are more expensive than passively managed funds. That remains an advantage for passive. But fees are coming down for actively managed funds — in large part due to the popularity of ETFs, particularly smart beta ETFs — so a big advantage for passive won’t be as large moving forward.
2. Active managers keep lower cash balances than they used to.
Mutual fund managers tend to keep some cash in portfolios to meet shareholder cash flows. This “cash drag” is underappreciated but can add up. For example, a fund with a 5% cash position when the market was up 20% last year gave up 1% in relative performance — that’s more than the typical expense ratio difference. This cash drag, however, tends to be a leading reason behind the apparent outperformance of actively managed funds in down markets. It also explains why passively managed funds have done so well in recent years versus actively managed funds. We are in the second longest and strongest bull market ever; cash has been a clear detriment in this environment.
However, actively managed funds don’t carry around cash like they used to as there are many ways to equitize cash now. So, while actively managed funds’ cash positions remain a net advantage for passive funds, this advantage for passive is also dwindling.
3. Actively managed funds tend to have smaller-cap tilts relative to passively managed funds.
Generally speaking, the bulk of passively managed funds are market-cap weighted, meaning larger companies have the largest portfolio weights. Most active managers, meanwhile, build portfolios with an equal-weighted construction process in mind. This creates a smaller-cap bias versus the broad market benchmarks. As a result, all else equal, actively managed funds will generally outperform when small-caps outperform large-caps, such as they have in recent years.
Currently, small-caps look attractive on a relative valuations basis and are expected to outperform over the next 10 years. If this occurs, it will be a net advantage for actively managed funds.
4. Actively managed funds tend to have value tilts relative to passively managed funds.
Since the bulk of passively managed funds are market-cap weighted and thus tend to flow into companies with higher growth rates and valuations, growth-oriented companies tend to have the largest portfolio weights. Most active managers build portfolios with some sort of valuation sensitivity when selecting securities. In general, and speaking in the aggregate, passive funds don’t consider company fundamentals or valuations, but active funds do. As a result, actively managed funds tend to outperform when value stocks outperform growth stocks, such as they have in recent years.
Currently, value stocks — after arguably the longest stretch of underperformance ever — look attractive on a relative valuations basis and are expected to outperform over the next 10 years. If this occurs, and I believe value could generate significant relative outperformance, it will be a nice tailwind for actively managed funds.
5. Actively managed funds tend to have some non-benchmark international exposure while passively managed funds, of course, do not.
Since the bulk of passively managed funds must track their benchmarks, they do not have non-benchmark exposure, which includes exposure to international securities. Actively managed funds, meanwhile, often do have international exposure.
Since international markets remain significantly more attractive than domestic markets, the ability to invest in some level of international equities should benefit active managers.
At CLS, the contrarian in us likes the fact that most of the world is moving towards passively managed funds and away from active management. While the move to passive has been in large part about lower investment management costs, which are obviously beneficial for investors, it is also another version of performance chasing. As we have often written, performance-chasing behavior costs investors even more than fees over time and is the leading reason investors underperform long-term.
As for examples of actively-managed funds that CLS Investments currently use:
Currently, our top two actively managed equity funds include:
- Davis Select Financial ETF (DFNL) — this ETF, managed by the famed value investor Chris Davis, captures what the Davis funds have provided for years: high-quality, long-term, low-turnover, value-oriented money management.
- SPDR MFS Systematic Growth Equity (SYG) — this ETF, meanwhile, comes from MFS Investment Management via State Street, which I believe is one of the great growth-oriented investment firms. Like Davis, MFS has been around a long time and continues to run the oldest mutual funds. Unlike Davis, this fund tends to be a bit more systematic, hence the name. But we believe it will provide quality growth-oriented investment management.
There are several funds within actively managed fixed income ETFs that we currently favor. The four highlighted below are managed by those I consider to be talented fixed-income managers and firms. All have provided attractive long-term performance, and all hold the promise to continue considering their organizational strengths, such as talent and resources. What’s most notable is each fund and firm plays the game differently. In other words, one could attain even more consistently attractive behavior by blending these various names.
- BOND — PIMCO Total Return ETF. PIMCO is arguably the premier fixed-income shop and has been for a few decades now.
- FBND — Fidelity Total Bond ETF. Fidelity has also been one of the top fixed income shops for decades.
- FIXD — First Trust TCW Opportunistic Fixed Income ETF. This fund is managed by the MetWest fixed-income team within TCW (and sponsored by First Trust). MetWest has a very active, value-oriented management style that has put up fantastic long-term numbers.
- TOTL — SPDR DoubleLine Total Return Tactical ETF. This fund is managed by DoubleLine’s Jeff Gundlach, who is well-known both for his performance and commentary.
Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel. He can be reached at Rusty.Vanneman@CLSInvest.com.
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.