Is active investing ready for a comeback?

For more than a decade, money has flowed out of actively managed funds into passive ones.

Active US equity funds’ last calendar year of net inflows was 2005. In contrast, ETFs are growing rapidly; in the first nine months of 2017, assets invested in global ETFs rose by almost 25% to reach a new high of USD 4.3 trillion. Equity ETFs have led the rise; they account for three quarters of the total, and passive funds are the vast majority.

The proportion of equity ETF and mutual fund assets that are passively managed has also grown significantly, as well as in absolute terms; rising to 46% from 22% in the US, and to 35% from 11% in Europe, since 2007. The ETF market is now more than USD 1trn larger than the entire hedge fund industry, and over 10% of the global equity market cap is now managed passively.

Investor preference for passive funds has been supported by lower costs and “risk-on, risk-off” equity markets, which made it difficult for active managers to outperform. Between 2013 and 2016, more than 93% of fund managers benchmarked against the S&P 500 failed to beat the market. Over a longer time period, active managers have still struggled. Less than 15% of US stock fund managers managed to beat their benchmarks over the past 15 years.

But while growth in passive investing in recent years is understandable, there are reasons why some active management strategies could outperform indexes in the future:

1. Falling correlations should help managers generate alpha. Earlier this month, one-month implied correlation between the S&P 500’s top 50 stocks fell to a record low of 9.2%, compared with a 20-year average of 44%. From 2000–2016, equity long-short strategies generated average annual alpha of 6.5% or more when correlation was lower than the median.
2. While S&P 500 stock price dispersion has yet to rise much, the dispersion in valuation between the cheapest and most expensive stocks is very wide (at the 80th percentile of the range since 1991). This suggests price dispersion could rise a lot if investor focus shifts to valuations – creating an attractive environment for long-short managers.
3. As normalizing interest rates replace loose monetary policy, active managers could see trading opportunities. Hedge funds typically outperform other asset classes when rates are rising. In the US, during the past three rate hiking cycles over the last 20 years, equity long-short hedge funds produced annualized total returns close to 14%, compared with slightly less than 8% for the S&P 500.

These dynamics are already having an effect. Returns to active management appear to be picking up. In 1H 2017, 54% of US active managers surpassed their benchmarks. As of end-September, global equity long-short hedge funds have gained 9.6% year-to-date, their best performance since 2013. If correlations stay low and price dispersion increases, this trend could prove durable.

Bottom line

For more than 10 years, passive investing has gained equity market share at the expense of actively managed funds. In equity markets driven by swings from risk-on to risk-off, active managers have struggled to outperform and only a small proportion have beaten their benchmarks. But now, low correlations, wide valuation dispersion, and monetary tightening suggest active managers may start to outperform.

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