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Active portfolio management involves picking stocks to outperform the market. Active management pays attention to market and economic trends and seeks to offer the potential for higher returns. Passive management, on the other hand, attempts to mimic a specific index and generate a similar return. This approach isn’t proactive and thus is typically associated with lower fees. There is an ongoing debate as to which strategy is better. The answer may depend on timing.
Over the past decade, passive management has grown in popularity. In 2016 alone, passive ETFs attracted $287 billion in new money. This growth has been driven by the sustained equity bull market. As CNBC notes, “You could have thrown a dart at the market and whatever you hit did well.”
This bull market favored passive funds that mimic indices like the S&P 500, which has had annualized returns of roughly 15 percent for the last three years. It is difficult to pick stocks that will outperform an index when almost all stocks are performing well. These returns, coupled with lower fees, transparency, liquidity, and the emergence of robo advisors, have led many investors to choose passive funds. However, passive funds may not fare as well as markets change.
Eight years in, the bull market may be overextended and a bear market may be on the horizon. Active managers are not locked into specific holdings and can invest in defensive stocks during down years. Passive index funds, in contrast, must mimic the indices they track and may end up suffering significant losses during bear markets. While active managers may not have hit their benchmarks during this bull market, according to Morgan Stanley, over the last 20 years, top active managers have outperformed their benchmarks in down years.
Additionally, rising interest rates may impact active fund management. Rates have been inching up since 2016 and are expected to climb through 2019. As rates rise, certain stocks and sectors become less correlated, presenting an opportunity for stock pickers. Record-low interest rates have hurt active managers. According to CNBC, in 2016, only 10 percent of active managers outperformed their benchmarks on a three-year-average basis. With rates rising, the proportion outperforming was up to 49 percent at the end of January 2017. It’s easy to see that recent interest rate increase trends have been positive for active managers.
There may never be a clear winner in the active versus passive portfolio management debate. It’s important for investors to have a mix of both while also taking current economic trends and forecasts into account. We believe that political change, the threat of a looming bear market, and rising rates may make this a good time for passive investors to consider the benefits of actively managed funds.
Justin Milberg is Chief Operating Officer for Liquid Alternatives at Resource, a leading real estate and credit investment management company.
Learn more at www.ResourceAlts.com.