Here Comes a Passive Investing Bubble; Long Live Active Management

It’s hard to go a day without reading an article touting the benefits of passive investing over an active strategy. The perception that stock pickers can no longer generate superior performance to justify the high fees they charge was on full display last year. In the first 11 months of 2016 investors redeemed some $285 billion from all actively managed U.S. funds while pouring $430 billion into index tracking mutual funds and exchange traded funds.

By any estimation the debate of active versus passive appears one sided with performance fees and efficiency all favoring the set it and forget approach. Between 2015 and 2016 a mere 15% of U.S. large cap mutual funds outperformed the Vanguard 500 Index Fund while charging annual fees of about 0.77 percent, compared to 0.10 percent charged by passively managed funds. At the moment, about 40% of total equity AUM exist in passive investment accounts, more than twice the level in 2005, according to the Goldman Sachs Global Investment Research group.

Based on the facts, it makes sense that cheap passive funds experienced an uptake in recent years. But the rapid rate at which money continues to flow out of active funds and into passive ones prognosticates an asset bubble. By definition, a bubble forms when prices rise significantly above the fundamental value of an asset. It can often be difficult to predict a bubble, but from a pure valuation standpoint stocks trading in index funds tend to be overvalued compared to those not in index like funds.

At the same time the broader S&P 500 index trades at 24 times earnings, reflecting a relatively rich valuation by historical standards. In other words, there is likely a correction period for index tracking funds looming in the shadows where underperformance persists for several years. 

Meanwhile a breakdown in cross asset correlations following the U.S. election points to the potential end of the pure beta (passive) play and start of a stock pickers renaissance. In the years following the financial crisis, active managers struggled to beat benchmark indices as correlations reached 67 percent. Historically speaking, long bull runs consistent with the one after the crisis routinely support a hands-off approach whereby an active strategy aims to maximize short term returns.

With that in mind, low asset correlations bode well for stock pickers as market drivers become more diverse and the linkage between assets break down. In the 7 years leading up to the crisis, large cap fund managers beating the market stood around 45 percent when correlations were on average 31 percent lower than the post crisis era. 

Furthermore, a drawdown in asset correlations can represent the late stages of an economic cycle. The current market conditions, which includes a new administration and steadily improving earnings, could conceivably cause a meaningful price shock in either direction, but more importantly, it spells increased volatility for the next few months. Conventional wisdom suggests greater volatility and dispersion provide skilled pickers more opportunities to shine relative to the indices they benchmark themselves.

In the same way that low fees decimated the active market recently, it will also help the industry make a comeback. Cheap passive vehicles forced most asset managers to cut prices to attract funds and make it easier to beat benchmarks after fees.

Although passive investing remains the topic du jour in the finance world, the balance of power appears to be shifting back to active management. But the likelihood of active managers outperforming the broad market in 2017 remains a mystery, especially due the rise of quantitative investing (that’s a different discussion). If the industry underperforms with all these factors working in its favor, it might be time for active managers to reevaluate where and how they add value.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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