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The debate between active and passive investments has continued to heat up over the past decade, in both industry and the academic arena. Since 2004, I have conducted a series of research studies comparing the historical and potential benefits of active investing with index-based, passive portfolio management in a broad range of investment categories. These studies have been published in several FundQuest white papers and broadly reported in the media.
My research leads me to conclude that both types of investing have their strengths and weaknesses; it depends on the market segment in question and on the economic climate. Active managers tend to add value in bull markets, but their value is shakier in bear markets. Many investors use active management in part to provide downside protection, but, on average, the active managers I researched did not outperform in bear markets after adjusting for risk. The results indicate that, to optimize their portfolios, investors should consider a blend of both active and passive investing.
Over the past few years, the industry has indeed gradually shifted towards a more blended approach. Today, active and passive investments are viewed by many as complements, not rivals. Many traditionally active investment management companies have begun to offer passive investment products in their lineup, and some index fund and ETF providers now offer “actively managed” ETFs. Now the key questions are where and when to use active management and how to identify skilled managers.
We at FundQuest recently released the latest version of our white paper, “
When Active Management Shines vs. Passive: Examining Real Alpha in Five Full Market Cycles over the Past 30 Years.” Compared to previous studies, this study doubled the research period from 15 years to 30 years, now covering the time period from
January 1, 1980 to February 28, 2010, which was divided into five full market cycles, including five bear markets and six bull market periods. From the beginning of a bear market to the beginning of next bear market was considered one full market cycle. Instead of looking at calendar year or trailing period returns, the study evaluated managers’ performance in three ways: over a full market cycle, in bull markets, and in bear markets. In doing so, the study provided insight on the market environments in which active management added value. In addition, the study identified some factors that have been shown to have an impact on real alpha generation.
This study included 19,908 live (in operation) and 12,083 obsolete U.S. domiciled non-index mutual funds in 73 categories representing over $7 trillion of assets in the Morningstar database. Obsolete funds were included in the data to minimize survivorship bias.
The methodology has been consistent in all studies. Real Alpha was used to measure the additional return truly stemming from the unique ability and skill set of the investment manager. Real alpha is a portfolio’s excess return over its best-fit benchmark, after adjusting for its level of risk as measured by beta. We regressed 86 market indices against each portfolio, and the index that showed the highest correlation (r-squared) between a portfolio and an index was chosen as the best-fit benchmark for that portfolio. Real Alpha is calculated as Real Alpha = Portfolio return - beta (Best fit benchmark return).
Of the 73 investment categories analyzed, a bias to active management was beneficial in 23 categories and a bias to passive management in 22 categories. The remaining 28 categories were deemed neutral, meaning that either active or passive may be appropriate). In terms of nine major U.S. equity style categories, an active bias was favorable for the mid-value and small-growth categories and a neutral position prevailed for large-growth, large-blend, large-value, mid-blend, mid-growth, small-blend, and small-value.
Many of the high alpha-generating categories (such as Emerging Markets Bond, Industrials, Equity Precious Metals, Diversified Pacific/Asia, Foreign Large Value, Foreign Large Growth, Foreign Small/Mid-Value, and World Allocation) were in the international markets and niche specialty sectors, which tend to be less heavily researched by U.S. investors. Some of the negative alpha-generating categories invest in very cyclical market segments (such as consumer discretionary, commodities, natural resources, Latin American equity, and Japanese equity). The growth of companies in cyclical industries and regions tends to be very sensitive to erratic macro factors and dynamic product evolvement (many consumer discretionary products quickly become obsolete, because newer and better substitutes are introduced to the market). As a result, these companies’ revenues and earnings can be very volatile and somewhat unpredictable. Unsurprisingly, active managers may have less of an edge in these areas.
Of course, there are managers generating positive real alpha even in categories where active managers have historically underperformed their benchmarks. The percentage of managers in each investment category that outperformed their respective category benchmarks varied significantly from category to category. Opportunities exist in every space, but rigorous due diligence may be required in the fund selection process to identify managers with potential to generate real alpha going forward.
One of the most significant findings of the study was that managers that provided better downside protection or generated high alpha in a full market cycle generally performed well in the following full market cycle, adding higher alpha. That said, past performance is not indicative of future results, and an active manager’s investment style can be in or out of favor in any given year.
Additionally, manager tenure, net expense ratio, and volatility (defined as standard deviation) had meaningful impacts on alpha generation (affecting returns by 10, -66, and -2 basis points annually, respectively), while turnover ratio, concentration level, and asset size didn’t have any statistically significant impact.
Another question advisors and investors might ask is whether active managers perform better in bull markets or bear markets. The results of the study indicated that active managers were generally more conservative and were exposed to less market risk than their passive benchmark indices, regardless of bull or bear markets. The average beta of all categories was found to be 0.80 in bull markets and 0.81 in bear markets. Before we adjusted for beta risk, active managers had, on average, generated positive excess returns in bear markets and negative excess returns in bull markets. However, the situation reverses after adjusting for beta risk; active managers generally generated higher real alpha (risk-adjusted returns) than their passive benchmarks in bull markets, and lower alpha than their benchmarks in bear markets.
The results of this study are actionable and can help investors optimize their allocations to active and passive investing within each investment category included in their portfolio. You can download a copy of this new white paper at: http://activepassivefunds.com/research.html.
Index and benchmark performance information is presented for comparison purposes only and does not represent the actual performance of any specific investment product or portfolio. Fees and expenses are not included in the performance of an index. Fees and expenses will reduce performance. An investment cannot be made directly into an index. Past performance is not indicative of future results. An individual investors’ situation can vary. Therefore, the information presented in this document should be relied upon only when coordinated with individual professional advice.
Jane Li, CFA, CAIA, is Manager of FundQuest’s Investment Management & Research Team and a member of the Investment Committee. She joined the firm in 2000.
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