The debate over active versus passive investing has raged on for years with passive strategies recently taking the upper hand particularly in terms of capital flow following the financial crisis. The superior investment performance by passive strategies since the end of the financial crisis has caused investors to question active management. This is highlighted by a record $50.8 billion of inflows to passive funds in the last month of 2016 alone while active funds marked their 33rd consecutive month of outflows.
What is active investment management?
Active management, also called active investing, refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index.
What is passive investment management?
Passive management, also called passive investing, is an investment strategy that tracks a market-weighted index or portfolio.
What is driving the trend toward passive management and is it sustainable? Passive strategies tend to outperform during periods of high correlation in the equity markets. The flood of money into passive strategies has caused shares to increasingly move together with correlations exceeding 90% in recent years. Additionally, this prevalent correlation trend has driven active managers who are fearful of being left behind to become more passive in their investment allocations. The combination of high correlation and benchmark-hugging has created a particularly challenging environment for active managers. This is due, in part, to an index fund’s lack of price sensitivity when purchasing equities, which means investors are buying more and more of a company’s stock as the market cap increases without regard for the stock’s fundamentals, valuation or risks. Despite their recent popularity, these momentum-driven markets have recently ended badly for investors with the tech bubble in the early 2000s and the financial crisis in 2008 as the most recent examples.
What is the benefit to active management?
There are a number of reasons to believe that experienced and active managers have the ability to generate above-average returns over the long term. Research shows that active managers have a higher chance of outperforming during bear (or falling) markets, when the correlation of returns within a benchmark is low and when market volatility increases. An actively managed portfolio can seek to avoid the securities that contain the greatest risks creating a level of downside protection that is not provided by a passive investment in an index.
With equity markets at all-time highs and valuations above historical levels, now may be a good time to research an active strategy that meets your long-term investment needs.