We take a look at how actively managed funds have fared during the recent market downturn.
We have previously talked about the ongoing debate regarding active vs. passive management. Proponents of passive management insist that active managers cannot consistently outperform a passive benchmark and therefore investors are better off to invest in lower cost index funds. Meanwhile, those in the active camp maintain that through their analysis and expertise active managers are able to produce persistent alpha. The question of active vs. passive is often framed with the premise that active or passive is always superior and focuses largely on the U.S. equity market. However, all markets are not the same and so we should examine the merits of each style on a market-by-market basis instead of taking a one-size-fits-all approach.
The key determinate of which strategy, active or passive, is superior is market efficiency. Market efficiency describes the degree to which asset prices quickly and rationally adjust to reflect new information. In a highly-efficient market, any new information is quickly incorporated into prices and therefore it is not possible to consistently achieve above average risk-adjusted returns in this type of market. Therefore, due to their lower cost, passive investment strategies are favored over active management in a highly-efficient market. In less efficient markets, on the other hand, the opportunity exists for skilled active managers to outperform passive strategies, thereby adding value for clients.
As mentioned above, the active vs. passive debate often examines only large cap U.S. equities, which is a natural starting point for the discussion – the large cap U.S. equity market is composed of the most well-known companies in the world and represents a large portion of many retirement portfolios. However, if we stop there we ignore what should be an obvious and fundamental element of the discussion – the various markets around the globe are unlikely to all be equally efficient. The very fact that that U.S. large cap companies are the most visible and researched firms in the world suggests that the U.S. large cap equity market is likely to be more efficient than its less-well-known counterparts!
In addition to variation across markets, individual markets can also have different characteristics in distinct time periods. During the 10-year bull market from 2009 – 2019 active managers, especially in the U.S. large cap space, often struggled to match the performance of their benchmarks. One common refrain from the active camp during that time period was that active managers were skilled at identifying quality and outperformed in down/volatile markets. As measured by the VIX, March was the most volatile month on record, so with that in mind we wanted to see how things shook out.
Below we've looked at the rankings of passive benchmark-tracking ETFs across five markets, U.S. large cap, U.S. small cap, international developed, emerging markets, and domestic fixed income. The graphs break each universe down into quartiles. If the passive fund is in the top two quartiles, that means that it outperformed the majority of managers in that market. We are primarily concerned with the two left-most bars in each image which display the rankings for the month of March and for the entire first quarter.
As you can see, between the domestic equity markets, active managers appear to have done best in the small cap space as the Russell 2000 Index Fund ranks right around the 50th percentile for both March and 1Q20, meaning that about half of active managers outperformed the passive benchmark. In the large cap space, the SPDR S&P 500 ETF SPY ranked within the top half of the universe in both March and Q1, meaning that less than half of the active managers in the space outperformed it.
In both the international and emerging market equity markets our passive funds ranked well above the median for both March and 1Q20 as a whole. The recent underperformance of active in these spaces is somewhat surprising, as we can also see that the passive funds fall in the bottom half of the rankings over the longer time periods displayed.
Clearly market volatility was not helpful to active US fixed income managers in this case. The passive index ranks in the bottom two quartiles over the longer time periods, but was well within the top quartile in March and Q1. Overall, the assertion that active management outperforms during down/volatile markets does not appear to have held true in this case as the passive funds did not rank in the bottom half for either the month of March or 1Q20 in any of the five markets we examined. Of course, one month's or one quarter's results are not enough for us to draw any sweeping conclusions, but, at least in this most recent downturn, the average active fund doesn't appear to have fared any better than the passive benchmarks.
