March 31, 2017—Active managers in domestic equities have had less success in outperforming their benchmarks in virtually each successive year of the current bull market. Starting in March of 2009 when the market finally bottomed and started upward, a bit more than half of active managers in the large-cap space were able to beat the S&P 500 index on a rolling 5-year time frame (Figure 1). By 2016, however, less than 15% of large-cap equity managers had managed to do so. Will this remain the case or could conditions be shifting that may give these active managers a better chance at success?
Percent of large-cap managers beating S&P 500 over a rolling 5-year period
Source: Source: Morningstar, Bianco Research
A variety of factors have contributed to the challenges faced by active managers, such as: persistently low economic growth; central bank policies of extremely low interest rates; low cost of and increased participation in passive investment instruments; and high-speed trading.
The economic recovery that began in March of2009 has been characterized by low economic growth, averaging about 2% per year. This led the Federal Reserve to keep its long-term interest rate at zero until the end of 2015 and rates are still very low. The central bank also took actions to push down longer-term interest rates. As a result, market volatility has been very low, especially recently, which has made it even more difficult for active managers to find outperformers. Of the factors listed above, economic growth is the area we see most likely to improve. With data already improving, the Fed has finally raised interest rates—in fact, three times in the past 16 months. The prospect of stronger and more variable growth from the Trump administration’s fiscal and regulatory policies should add to growth and be beneficial to active managers.
The accommodative policies of the Federal Reserve have tended to push down interest rates and keep GDP growth from advancing quickly enough to keep any economic problems from developing. The policy has kept recessions and depressions from taking place but it has also kept a lid on allowing markets to generate the kind of dynamics that is needed for active managers to perform well. This is shown in Figure 2, which shows the outperformance of active managers against the level of the fed funds rate since 2000. When the rate was declining or very low, less than half of active managers outperformed. When the fed funds rate started to move up again, relative performance improved. With the economy doing well enough that the Fed finally feels sufficiently comfortable to raise rates, the age of repression may be at an end. Furthermore, the Trump administration’s intentions with respect to de-regulation and tax reform could open the door for even stronger economic growth which should add to the opportunity for active managers to begin making a comeback. Both of these will likely remove the constraints we have been experiencing, allowing us to perhaps move back toward a more traditional business cycle.
Outperformance of active managers against the level of the fed funds rate
Source: Strategas Strategic Partners, LLC; Bloomberg
As the economy improves and the Fed continues to raise rates, the environment for active management could begin to gather steam in other ways. Active managers play a critical role in the financial markets by advancing the fortunes of good companies and penalizing bad ones. In a world dominated by passive investing, the good and bad companies are painted with the same brush as investor money is put to work buying both of these indiscriminately. But as active managers gain traction and less money heads toward passive investments, we can expect the indiscriminate market support to wane, thereby enhancing the ability for active managers to differentiate themselves from their indices.
Apart from our large-cap domestic market, we believe that some of the other equity markets across the globe lend themselves to active management. This is particularly true in such areas as developed and emerging markets, where the enormous breadth of geography and relatively less-developed financial markets result in more varied economic conditions and greater opportunity for active managers to identify winners and avoid losers.
At Wilmington Trust, we have advocated a mixture of active and passive managers. Both styles have risks and we have focused our efforts on managing these. We want to make sure that our clients benefit from both the tactical asset allocation decisions we make as well as the potential outperformance that individual mangers may generate. We believe this can be accomplished through a thoughtful mixture of active and passive styles that is adjusted as market conditions warrant. We will be keeping a careful eye on how the current evolving economic policy shifts impact these investment styles.
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