I’ve been thinking a lot recently about whether actively managed funds can beat the market.
I don’t mean whether this fund or that fund will beat the market; the answer to that is clearly “I don’t know (and neither do you).” I mean whether active funds in aggregate can beat the market.
The question is top of mind because the bull market is long in the tooth. Even die-hard ETF and index fans have been asking me lately if now is the time for active management.
The idea blew up on social media earlier this week when DoubleLine Capital CEO Jeffrey Gundlach told investors to take index funds and “throw them out the window,” singling out the S&P 500 as primed for underperformance. The meme, however, has been there all year:
- Forbes.com called 2017 “The Year of the Active Manager.”
- Barron’s labelled 2017 a “Stock Picker’s Delight.”
- Morgan Stanley said active management would “re-emerge” in 2017.
- Nomura called for an active management “renaissance.”
If these calls sound familiar, they should. We heard a similar story in 2016 (CFA Institute, Barron’s), 2015 (Neuberger Berman and Barron’s again), 2014 (Bob Doll), 2013 (Forbes) and so on. None of those panned out, but hope springs eternal. Could 2017 be the year?
Let’s examine the arguments.
Argument No. 1: Active Funds Do Well In A Bear Market
The first argument people make is that active funds do better than index funds in bear markets. On a practical basis, this argument is silly — if you knew we were entering a bear market, you would sell out of your equity positions entirely, not rotate into active funds. Nonetheless the argument persists, as it sounds plausible for two reasons.
First, active managers have the ability to tilt their portfolios toward defensive stocks, or to move into cash during bear markets, whereas index funds generally must stay fully invested. Why drive off a cliff if you see it coming?
Secondly, most active funds keep a 3-5 percent cash cushion on their balance sheets, effectively reducing their beta to the market.
The intuitive appeal of this argument, unfortunately, is undermined by the data. The Standard and Poor’s Index vs. Active (SPIVA) report looks at the percentage of actively managed funds that outperform the market. As you might expect, active funds tend to trail the market: in fact, a majority of large-cap U.S. Equity funds have trailed the S&P 500 Index in 13 of the past 16 years. Importantly, there’s no evidence that down years help — the majority of active funds trailed in all three down years for the market.
|Year||Total Return||% of Large-Cap Active Funds That Trailed the Index|
Argument No. 2: We’re Entering A Stock Picker’s Market
A slightly different form of the argument above holds that “we are entering a stock picker’s market.” By this, people usually mean that the correlation between stocks in the S&P 500 is down, which is definitively true over the past six months.
Like the bear market argument, it’s easy to see the appeal of this idea. Take two automakers: Ford and GM. For the year ending May 11, 2017, GM’s stock surged 14 percent while Ford plunged by a similar amount. This 28 percent spread created a perfect stock picker’s market for car companies. If you did your homework and concluded that GM was better positioned than Ford, you crushed it.
Rewind one year and look at the period ending May 11, 2016 — the two companies moved in lockstep, ending the year less than 1 percent apart. Do all the research you want; it wouldn’t have mattered.
It’s easy to see why active managers would prefer the first market over the second one. Why even bother with market No. 2?
Sadly, this argument falls apart under even the lightest scrutiny.
The problem starts with the idea of correlation. Correlation is simply whether two stocks move in the same direction: If stock A goes up 1 percent and stock B goes up 100 percent, they’re perfectly correlated. Obviously, however, a 99 percent difference in return creates plenty of opportunity for skilled active managers to prove their worth. That’s dispersion, and dispersion is what active managers should really be concerned about.
Fortunately, there’s almost always plenty of dispersion. As one Vanguard study pointed out, in every year between 2007 and 2011, roughly two-thirds of the stocks in the Russell 1000 index returned more than 10 percent above or below the index. Unfortunately, a strong majority of active managers trailed the market over that five-year stretch.
Wider dispersion in stocks does impact active managers; the data suggests it leads to a wider dispersion of active manager returns. Unfortunately, it has no impact on average performance: most funds still get crushed.
Argument No. 3: The U.S. Is Overvalued
While Argument No. 1 and No. 2 are not particularly appealing on examination, Argument No. 3 — the core of Jeffrey Gundlach’s argument — is more interesting.
In his interview, Gundlach pointed out that the U.S. market represents more than 50 percent of global market cap, but just 25 percent of global GDP, and that U.S. stocks are priced substantially higher than emerging market stocks using any valuation measure you care to use.
This is objectively true. The iShares Core MSCI Emerging Markets ETF (IEMG) trades at a P/E ratio of 16 compared to 24 for the S&P 500, according to FactSet. This discrepancy exists despite the fact that emerging markets are growing faster. Gundlach’s recommendation: Short the S&P 500 and buy emerging markets.
It’s worth considering, if only because most U.S. investors are woefully underinvested in Emerging Markets to begin with. According to Morningstar, the average investor has a 3-4 percent allocation to Emerging Markets, while Emerging Market make up 10 percent of global market cap. Moreover, you could argue that Emerging Markets themselves are underrepresented in the market, as evidenced by the gap between their weight in the MSCI World Index and their share of GDP. The core of my own portfolio is managed by Wealthfront, where I have an 18 percent allocation to Emerging Markets. I’m extremely comfortable with that.
Even Gundlach’s argument, however, isn’t a cincher: Studies of tactical asset allocation funds show that very, very few of them have beaten a simple 60/40 balanced portfolio over time. Gundlach may be an outlier — that rare bird that can identify bubbles before they burst — but the odds aren’t in favor of the average tactical manager beating the market.
Hope Versus Data
I understand why these arguments pop up when the markets get stretched. The inherent flexibility of active management gives it the opportunity to sidestep market pullbacks, which sounds great, and I’m sure some managers do. The data, unfortunately, suggests that most managers will fail and that it’s extraordinarily hard to pick in advance the ones that won’t.
Matt Hougan is CEO of Inside ETFs, the world's leading ETF conference and webinar company, and managing director of global finance for Informa PLC.
Matt Hougan is a keynote speaker at the upcoming Inside Smart Beta conference, taking place June 8-9 in New York City. View the agenda and register here.