Active, Passive, and an Aging Bull
So what does cyclicality in active and passive management performance mean for you, the investor? We believe it demonstrates the importance of maintaining perspective (and sight of your investment goals) over time, and minimizing the undue influence of fickle market sentiment as you navigate changing market cycles. Instead of letting recent performance enchant you into chasing returns, you should instead consider current market conditions and what the future could hold.
As shown in FIGURE 4, the current bull market in equities is nearly a decade old, making it the longest bull market on record.4 Not only that, the value of the S&P 500 Index has more than tripled since its low in March 2009.5
At the individual sector valuation level, the S&P 500 Index has a historical price/earnings ratio (the ratio of a stock’s price to its earnings per share) of 18.7. As of the publication of this piece, this ratio is close to the historical average. FIGURE 5 illustrates that although we’ve been in a bull market for about a decade, eight out of 11 sectors in the S&P 500 Index are trading at a discount to their 30-year historical average. Active managers have the flexibility to seek out opportunities in undervalued sectors, while passive investments are locked into the sector allocations determined by the index.
While this bull has run for years, it hasn’t been immune to occasional corrections (as measured by a loss of 10% or greater) to help keep it healthy. Like speed limits on highways, market corrections are a necessary evil in investing, but not one to be feared. They keep markets from becoming overinflated and prevent valuations from reaching heights that lead to damaging crashes. They can also provide opportunities for active management.
Active Management Has Fared Better During Corrections
The most recent market correction arrived in December 2018. When corrections occur, you may not want to be exclusively invested in passive. Instead, you may want to consider investing in actively managed funds.
There have been 26 market corrections over the last 31 years. FIGURE 6 shows that during those corrections, active outperformed passive 15 out of 26 times, with an average rate of outperformance of 1.3%.6 Again, we compared active to passive by removing index and enhanced index funds from the Morningstar Large Blend Category to represent active, and used the S&P 500 Tracking category to represent passive.
By allowing investors to respond to ever-changing markets, active management empowers investors to maximize opportunity as conditions demand. But if you’re locked into an index fund, you could be exposed to significant downside due to single-sector performance. For example, during the collapse of the dot-com bubble in 2000, active management outperformed passive significantly, -0.3% to -9.50%.7 Much of the blame for passive’s underperformance during that period can be laid at the feet of a single sector.
As FIGURE 7 shows, the technology sector made up almost 30% of the S&P 500 Index at that time. The sector (as represented by the S&P 500 Information Technology Index) crashed hard, to the tune of a 38.71% decline in 2000.
Meanwhile, the average active manager was significantly underweight technology relative to the index (21% vs. 30%), which helped limit the damage done to their portfolios when the tech bubble burst. Active managers with a positive return during this time were more underweight to technology with 15%, and those with a negative return hewed closer to the index with a 28% weighting.8 For a more recent example, one need only look back to the decline in oil prices in 2014 to see how passive investors were hurt by their inability to reduce exposure to an underperforming sector.
When bull markets inevitably turn, passive managers could be left holding stocks and sectors with poor fundamentals and inflated valuations. Meanwhile, active managers have the ability to mitigate risk by reducing exposures to expensive areas that will be hit hardest, and conversely, increase exposure as sectors or asset classes recover to capture upside as the new market cycle begins.
Investment Implications:
This insight focused on active vs. passive investing in the Morningstar Large Blend category because it’s widely believed to be the most efficient category—the one that should invariably favor passive investing. Yet even this category shows the cyclical nature of active and passive performance. The same cyclicality is present in other investment categories such as mid-caps, small-caps, and global/international equities.
Just as we think declaring active management dead is premature, we don’t contend that active management is the only suitable choice for investors. Far from it. We believe that the choice between active and passive management is not a zero-sum game, but that each has a place in investor portfolios based on the individual needs and wants of the investor. With that in mind, here are some conclusions to take away from this piece:
- The performance of active and passive management is cyclical, meaning each style goes through extended periods of outperformance.
- When evaluating active and passive management, looking beyond recent performance and measuring active share is important.
- As we saw in December 2018, market corrections are inevitable and a common occurrence in equity markets over time.
- There have been 26 market corrections over the past 31 years, and active management outperformed passive management in 15 out of 26 corrections.
- During market corrections, the flexibility of active management allows for reducing exposure on the downside and ramping up exposure to capture alpha in the early stages of recovery.
1 The measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark.
2,3 Source: Morningstar Direct, 1/19
4 Data Sources: Ned Davis Research and Hartford Funds, 2/19
5 Data Sources: Morningstar and Hartford Funds, 1/19
6 Source: Ned Davis Research, 2/19
7 As represented by the S&P 500 Index, from 1/1/00 to 12/31/00
8 Source: Morningstar, 2/18
This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This material may not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.
All investments are subject to risks, including the possible loss of principal.
Hartford Funds Distributors, LLC, Member FINRA.
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