Is Now the Time for Active Investing to Make a Comeback?

MONDAY, MARCH 18, 2019

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Is Now the Time for Active Investing to Make a Comeback?

Lower fees and rising volatility are making active management more competitive, supporters say. But critics say the odds are on the side of passive investing.

Few rifts in the world of mutual funds are as pronounced as the one dividing advocates of active management from those of index, or passive, investing.

For years, the flow of new assets, reflecting investor preferences, has tilted more to lowcost index and exchange-traded funds than to active funds.

Index funds have boomed in the decades since their introduction by the late John Bogle because they capture the returns of entire markets and so eliminate the "middleman," the stock-picking fund manager, with his trading costs and fees. When markets rise over time, the passive camp says, it only dilutes one's profits to pay premiums for managers who mostly, in any given year, fail to outperform the indexes of the markets in which they specialize.

But active management's supporters say the game has changed in recent years. Many active managers have had to lower their fees to remain competitive. And proponents believe that the reduced gap in expenses in many cases is more than justified by the expertise some managers offer--especially in these volatile times.

Martijn Cremers, a dean and professor of finance at the University of Notre Dame and a consultant to investment management firms, argues in favor of active management. Rick Ferri, a financial analyst, investment adviser and industry consultant, argues on behalf of passive investing.

YES: Lower fees and rising volatility make active management more competitive

By Martijn Cremers

Now is the time for actively managed funds, as long as they are truly active. The explosion in passive investing in recent years has led many active managers to lower their fees, making their services more affordable. Active management takes advantage of mispriced securities, and in the process mitigates the mispricing. Thus with fewer active managers there are more opportunities to find mispricings. And, for portfolios stuffed with passive

products, active management provides critical diversification in this time of heightened volatility.

Recent academic evidence challenges the conventional wisdom that active management typically does not generate value for investors. New research repeatedly shows that active managers have performed better than many people realize, as I and my co-authors concluded in a recent survey article which considered the findings of more than 200 research papers. In particular, improved methodology and more data show that the typical active fund manager has skill and does not underperform after fees.

Broad generalizations of active funds, like comparisons of the average performance of large-cap active funds and an S&P 500 index fund, are noisy and do not lead to any strong conclusions. Rather than using the average performance of actively managed funds as a basis of comparison, as critics like to do, moredetailed distinctions among active funds lead to insights with more statistical confidence. A study I co-wrote introduced active share, the proportion of a fund's holdings that differs from the fund's benchmark, to distinguish between truly active funds and those closely matching their benchmark indexes. We found that when active funds have holdings that significantly overlap with their benchmarks-- with active shares below 70%--they tended

Mutual-Fund Assets

Total net assets for active and index mutual funds

Active funds Index funds

trillion

trillion

Source: Investment Company Institute

to underperform their passive benchmarks. In contrast, high-active-share funds did not underperform after fees.

Fees matter, especially for funds with lower active share. Active funds earn back their fees by being distinct from the market--that is, through the active share of their portfolio that differs from their benchmark holdings. My main advice is to avoid funds with active share below 70% unless they have low annual fees (say below 60 basis points).

On the other hand, funds with high active share and patient strategies have outperformed their benchmarks after fees in the long run. As it is hard to be patient in today's impatient world, the combination of patient and high-active-share investing requires substantial conviction and trust. But high conviction acts like a constraint preventing too much capital from flowing into such strategies and diluting results.

(I make my academic data on active share and manager patience for U.S. equity funds

(over please)

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freely available on my website activeshare. info.)

Active management also provides protection in volatile markets. Indexed products tend to be highly correlated with markets, and with each other. Active managers, by contrast, can provide not only useful diversification but also increased downside protection. A paper published in 2013 in the Journal of Finance introduced methodology to find the 25% of active fund managers who perform well no matter how the market is doing. These managers do well at stock picking during booms and at market timing during recessions, significantly outperforming other active funds and passive benchmarks.

Critics of active management like to cite what Alan Greenspan said in 1998 about the folly of attempting to build "a better mousetrap that could consistently extract abnormal returns from the financial markets." Mr. Greenspan was referring to the collapse of Long-Term Capital Management, which used active management. But LTCM was overly dependent on leverage and thus sensitive to collateral or liquidity constraints. Many active managers follow prudent strategies without high leverage or collateral/liquidity constraints. Truly active funds with highconviction strategies help investors in the long run.

Dr. Cremers is a dean and professor of finance at the University of Notre Dame, an independent director at Ariel Investments and a consultant to investment management firms.

NO: Despite fee cuts, history is on the side of passive investing

By Rick Ferri

Active managers don't get smarter when markets become volatile. They don't pick better stocks, they don't time markets better and their fees are not lower. In fact, the fees go higher.

Will active managers outperform in 2019? I can't answer that question. But history doesn't put the odds in their favor.

I compared the returns of actively managed mutual funds in the Morningstar large-capblend category against the Vanguard 500 Index Fund from 1979 through 2018. During any given year over the past 40 years, the Vanguard fund, which tracks the S&P 500 index, held the advantage about 60% of the time. In 10 of those years, stock prices declined; the Vanguard fund outperformed in half of those years, and active management won the

other half. In the most recent three years when prices fell, the Vanguard fund outperformed in each year. Hardly a reason to switch to active management now.

Single years are interesting but not the whole story. Based on the latest S&P Dow Jones Indices SPIVA U.S. Scorecard, which compares returns of indexing versus active management, the return of the S&P 500 floated higher over time due to the benefit of compounding. Over a five-year period, the S&P 500 outperformed 80% of its active peers, and over a 10-year period it outperformed 90%.

While it is true that index-fund fees have forced down active-management fees, active management is still 10 times more expensive than low-cost, passive-index investing, which drags down the return on the active funds. Meanwhile, even with lower fees, the number of active managers outperforming has not changed. And when you dig into the managers that have outperformed, it isn't the lower-cost active managers. The ones who have outperformed have medium costs.

If anything positive can be said about active funds during past periods of poor market return and higher volatility, it's that managers raise cash out of necessity for shareholder redemptions. I do not consider raising cash for redemptions as skilled market timing, though it can provide a small cushion in poor market years. But this doesn't happen in every bear market. During 2008, the worst year for stock prices in 50 years, the Vanguard 500 Index Fund still outperformed its peer group.

There are many studies that claim some active managers have some skills when measured in unique highly quantitative methods that individual investors do not use or consider. The information might be useful for large institutions that are looking for niche coverage, but it's not useful for individual investors who compare performance to known market benchmarks.

ETF Assets

Total net assets for active and index exchangetraded funds

Active ETFs Index ETFs

billion

billion

Note: Includes funds registered and not registered under the Investment Company of 1940.

Source: Investment Company Institute

There will always be active managers who outperform. No one is disputing that. What isn't known is which ones will outperform in the future and by how much. That cannot be known. In the long run, most active underperformers lag by a bigger margin than the few outperformers win by. So, you take big risks for little gain.

Has anything changed in 2019? Factor funds, which use algorithms to select securities based on market trends, may lower activemanagement costs, and this may tilt the odds. Or perhaps there is hope in new artificial-intelligence funds. I'm always skeptical. Every time I hear, "This time it's different", I think of Alan Greenspan testifying before Congress in 1998 after the failure of Long-term Capital Management:

"This decade is strewn with examples of bright people who thought they built a better mousetrap that could consistently extract abnormal returns from the financial markets. Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist."

Indexing isn't perfect all the time, but it has beaten active management over time. There's no reason to believe this will change in 2019 or beyond.

Mr. Ferri is a financial analyst, investment adviser and industry consultant.

WSJ: Martijn Cremers--Active Investing Comeback? (EPRINT) ?3/19 (exp 9/26/19) AI-563

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