From Beta to Alpha

Among all the debates in the capital markets today, perhaps none is more acute than the role of active vs. passive management in the years ahead. On a high level we suggest both have an important role to play, but there’s a story within the story that is critical for investors to go forward. From the active perspective, it’s no secret that as the data shows, many managers have struggled to beat their indices over time. But an important thing to keep in mind is that the level of success varies a great deal by market segment, time period, environment and perhaps most importantly by level of active. A well-known study looks at that. The overall market as they found, underperformed over a 20-year period by about 40 basis points per year, but if you break it down into the most active 20 percent, as defined by active share and low tracking error, that performance number jumps to 126 basis points of outperformance per year, after fees for 20 years. Being active, and the due diligence around that, matters a great deal. As does the environment.

Put simply, in a great rising tide, the boats don’t matter. In periods of market returns greater than 10 percent, about a third of managers outperform. Less than 10, over half did. Look at that over a period of time and that narrative jumps out.

In rolling three year periods of performance vs. the rise of the S&P, note the build-up to the tech bubble and the post-financial-crisis response to find the most difficult active manager performance. Look at all other time periods and once again get to that north of 50% number and so the environment matters a great deal.

And we believe that environment’s changing, based on valuations history suggests that over the coming decade returns will be less than 10% per year. Which suggests that the quality of the boats will take on greater relevance as the tides recede. On the opposite side of the ledger, passive investing has brought tremendous benefits to investors in terms of access and the lower cost of that access to markets, but the sheer growth in those assets lays its own potential challenges.

Most notably is simply the number of vehicles. Did you know today, that out of the roughly 2500 or so liquid stocks in the world, we’ve found a way to combine that into nearly as many ETFs and growing and so we’re remixing the allocations from the same pool of stocks. But that’s also leading to some unintentional crowding if we look in aggregate at what all of those ETF’s collectively own.

More and more investors find themselves in the same spaces and the most passively held stocks have much greater volatility and are showing higher correlations to each other as part of the crowded universe. We also have to marry crowding to something called fragility, the flight risk of investors within market segments as the line up behind a single outcome. And liquidity - if they do flee, what is the availability and cost to exit the markets in difficult times. And finally, if you are investing in a broad segment of the market, what happens if a crowded trade lives inside of that, we believe you end up having to sell the bathwater instead of the baby. These four horsemen matter a great deal to investors over the coming years, along with the sheer growth in the number of offerings available to investors, like what we see in the rise of low volatility.

These are the types of factors you have to think about when consider the roles of active and passive equities in your portfolio.