Active managers can and do outperform their indexes, and investors can identify managers more likely to outperform in advance, according to “A More Balanced Narrative – Setting the Record Straight on Active Management,” a new white paper positing that the conventional wisdom on active management is oversimplified.

The white paper, presented by the Investment Adviser Association’s Active Managers Council (AMC), examines the current narrative surrounding active and passive investing and challenges the three most common criticisms of actively managed investments: active managers don’t outperform their indexes; active managers can’t outperform their indexes; and identifying above-average active managers isn’t possible.

In fact, active managers are doing well in some categories and poorly in others. The narrative that passive is winning almost everywhere isn’t supported by either standard total return comparisons or asset-weighted return estimates, argued white paper author David Lafferty, AMC Chair and Natixis Investment Managers senior vice president and chief market strategist.

“The growth of passive investment strategies is well-deserved, but in recent years, the narrative between passive and active has become unbalanced,” Lafferty said.

“This paper presents a more balanced discussion of the factors that drive relative performance between active and passive investing, examines the methodologies for comparing the two approaches, and argues that passive investing is raising the bar for active managers,” he added.

A few of the key findings from the paper include: 

• Many Active Managers Do Outperform: The popular narrative has been that active managers are underperforming across all styles and during all periods. However, a review of the data shows that the relative performance of active and passive managers varies across both styles and time periods. 

“This is not an attempt to gaslight academics or researchers studying active and passive management. It’s simply a reminder that results are dependent on assumptions and far from precise,” according to the white paper.

A look at two popular “scorecards,” the Morningstar Active/Passive Barometer and the S&P Index Versus Active (SPIVA) report illustrate this point. For the three years ending 2018, Morningstar reported that 59% of mid-cap growth funds outperformed the passive alternative while SPIVA reported that only 46% of mid-cap growth funds outperformed. The dispersion between the two scorecards was even wider in small-cap growth, where Morningstar reported 51% of active funds outperforming to SPIVA’s 24%.

“To read the headlines, you’d think active management lags in all places and nearly all times. In fact, it’s largely in US large cap stocks that the data has been sub-par recently for active managers, but this is hardly the message investors hear,” according to the white paper. “Yet the difficulty that US large cap blend managers have had beating the S&P 500 – the largest category with the most well-recognized benchmark – has been incorrectly extrapolated to convict active managers across all the other categories.”

• Zero-Sum Theory Does Not Prove the Average Manager Can’t Outperform: While Sharpe’s “Arithmetic of Active Management” may be compelling in terms of the overall availability of alpha to active managers, the math doesn’t perfectly align with how active management is measured in industry practice, the white paper argued.

Excess returns can be skewed across managers, and there is meaningful “slippage” across categories and investor types. The fact that alpha in total must equal zero does not mean that the median professional manager in a category will have 0.0% excess return before fees (and negative excess return after fees), Lafferty asserted.

• It’s Possible to Identify Outperforming Managers in Advance: While Lafferty is not suggesting that active manager selection is easy, he makes a compelling case that there are factors that can substantially increase an investor’s ability to identify a manager who will outperform. These factors include cost, benchmark differentiation and time horizon.

• Active Managers Are Raising Their Game: The competitive pressures from passive indexing are leading active managers to raise their game. They are lowering fees, investing in investment processes, increasing portfolio differentiation and focusing on risk management.

The industry’s movement toward lower cost is well underway. The average expense ratio for actively managed equity funds have fallen from 1.06% in 2000 to 0.76% at the end of 2018 – a 28% drop. As active managers continue to cut fees and investors demand more stripped down share classes, fewer structural laggards will be left in the active universe, according to the white paper.

“Our goal is to counter the oversimplified conventional wisdom that has created a false dichotomy pitting active vs. passive management,” said IAA President & CEO Karen Barr. “Taking a deeper look at these topics yields a much more nuanced understanding of both active and passive investing styles – and how each can play an important role in investors’ portfolios.”

No doubt, the growth in indexing has been a call to action for active managers. The competitive pressures emanating from cheap passive strategies are forcing active managers to up their game and reassess the competitiveness of their fees.

“Over the years, declining profit margins have been pushing active managers to streamline and focus squarely on activities that produce alpha,” Lafferty said. “Active managers will increasingly turn to technology pioneered by their passive peers to reduce labor costs and trade more efficiently.”

Active strategies also stand to gain from one of indexing’s inherent weaknesses: the inability to manage risk. “The major market-cap and issuance-weighted indexes are fully invested at all times and provide pure beta, delivering all of what the market provides, good and bad,” according to the white paper. “Since 2009 this has been a boon for passive strategies as global stocks have risen and interest rates fell. But at some point, the bear will return, and when it does, investors will rediscover the other side of holding assets on autopilot.”