Radioactive: Is Passive’s Dominance Over
Active Set to Wane?
February 28, 2017
by Liz Ann Sonders
of Charles Schwab
Key Points
Monetary policy, growth and inflation conspired to elevate correlations and passive’s
outperformance over active
But the winds are shifting and regimes are changing; supporting a better environment for active
management
A balance between the two strategies will likely serve investors best
One of the key themes I and my strategy colleagues highlighted in our 2017 outlook was the regime
change from monetary policy being the only game in town to fiscal policy taking at least one of the
reins. There are important implications of this shift—key among them is likely a shift from passive
(index-oriented) investing strategies being rewarded with both strong performance and flows, to more
active strategies garnering more flows and generating better returns. The latter have struggled
throughout the current bull market. The usual inefficiencies seen in market pricing waned, making it
more difficult for actively-managed funds to find an edge and outperform.
Passive has crushed active
In the double chart from Ned Davis Research (NDR) below you can see these trends. The top field
shows the outperformance by passive ETFs relative to active mutual funds (23.5% vs. 9.2%,
respectively, compared to the S&P’s 16% annualized return). The bottom field shows the significantly
stronger in growth in passive assets relative to active assets.
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Two performance cases in point
First, hedge funds—dominant in active strategies—have underperformed the S&P 500 every year
since 2008, according to Strategas Research Partners. It's the longest stretch of underperformance in
the history of hedge funds. Second, in the seven full years during this bull market—2010 through 2016
—only one-third of U.S. large-cap growth active managers outperformed the Russell 1000 Growth
Index, according to Morningstar data.
Low volatility/growth/rates supported passive
In addition, volatility has been exceptionally subdued, which has also been to the benefit of passive
over active. Perhaps not imminently, but we do believe volatility is likely to rise, which would be to the
benefit of active over passive. Also subdued has been economic and earnings growth, which makes it
more difficult to differentiate the stock market’s winners from the losers. Today though, tighter
monetary policy is reflecting a stronger growth outlook, while earnings growth is surging from its fourquarter "recession," which ended in the third quarter of 2016.
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The Z/NIRP (zero/negative interest rate policy) era was defined by "risk-on, risk-off" trading, causing
correlations within and among asset classes to shoot higher; and investors to question the merits of
diversification. The chart below shows the dramatic plunge in the S&P 500's 65-day rolling correlation.
This means that the stocks within the index are no longer acting similarly—a lower correlation means a
higher dispersion among returns.
Source: Strategas Research Partners, as of February 24, 2017.
The same can be said for correlations among global equities. Again, a lower correlation means a
higher dispersion among returns of global equity asset classes. It’s making the argument against
diversification more difficult to make.
Source: Strategas Research Partners, as of February 24, 2017. Rolling 52-week correlation among:
S&P 500, Germany DAX, France CAC, UK FTSE 100, Spain IBEX, Swiss SMI, & Japan Nikkei.
The aforementioned environment caused an epic shift of investor assets from active, like traditional
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actively-managed mutual funds; to passive, like exchange-traded funds (ETFs). As you can see in the
chart below, traditional domestic mutual funds have been bleeding assets nearly every year since
before the financial crisis; while ETFs have picked off many of those flows.
Source: Investment Company Institute (ICI), as of December 31, 2016. Chart plots domestic equity
fund flows.
My friend and founder of Strategas, Jason DeSena Trennert, had this to say in a recent report on the
subject of active vs. passive: "The good news for active managers, is that we are entering a sweet spot
in which real rates are still low and stimulative but in which inflation is rising fast enough for the
markets to ration debt capital. While this may lead to lower aggregate Index returns at precisely the
time so many investors have become so enamored with passive investment strategies, it will also likely
lead to a divergence of fortunes among companies that should allow stock pickers to once again have
their day in the sun."
Caveats and the bottom line
Although we do believe the macro winds are shifting more in favor of active strategies, there are
several important caveats. Most importantly, at Schwab we believe in both. In fact, our studies have
shown that an allocation which blends both passive and active strategies has generally outperformed
strategies that solely focus on one or the other. In addition, the fees investors pay for these vehicles
will continue to be a factor. According to NDR and the Financial Times, the average expense ratio of
U.S. equity funds dropped from 99 cents for every $100 invested in 2010 to 68 cents in 2015; however
passive funds remain cheaper. What I’m suggesting is that the trajectory of passive’s dominance over
active is unlikely to persist without some reversion to the mean.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered
an individualized recommendation or personalized investment advice. The investment strategies
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mentioned here may not be suitable for everyone. Each investor needs to review an investment
strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Data contained herein from third party providers is obtained from what are considered reliable sources.
However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can
expect to achieve.
(0217-VL3H)
© Charles Schwab
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