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Suddenly, actively managed funds are sexy again

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Passive beats active investing. It's a mantra repeated so often it seems to be a truism.

But is it?

Yes, sometimes passive outperforms active portfolio management. During 2014, only 10 to 20 percent of active domestic, large-cap managers bettered their benchmark indexes, according to data culled from a Morningstar database. Passive indexing bested active managers during much of the current bull market, which began in 2009.

Still, I believe in the cyclicality of the two styles of investing. There have been numerous periods when most large-cap, active money managers outperformed. One particular timeframe, 2005, just before the Global Financial Crisis, about 80 percent of active managers beat their benchmarks.

No one can predict with absolute accuracy which investing style is better for any future time frame. Two past trends, however, may be appropriate guides for some investors.

One trend is contrarian: When passive investing is at a peak, active investing is at a point of "maximum pessimism," which is also when the downward trend starts to reverse.

In other words, sell when others are ebullient and buy when others are fearful. It has been proven again and again over decades. Just ask Sir John Templeton or Warren Buffett.

The second trend: interest rate direction. History shows that when rates are rising, active management outperforms passive management.

Why?

When rates go up, lower correlations, or higher dispersion, between stocks and sectors occurs. This phenomenon places a premium on stock picking skills.

"Maybe it's time to think contrarian and buck the trend of money flowing out of actively managed funds into index funds. It may finally be the time for active managers to shine."

Conversely, when rates go down, high correlation, or lower dispersion, appears, meaning a large percentage of stocks move up or down in tandem. When this happens, active managers tend not to be rewarded for their fundamental research.

For example, from 1962 through 2014, according to Nomura Securities, active managers surpassed their indexes by an average of 1.5 percent in years when rates moved higher, and they underperformed by an average of 2 percent when rates moved lower.

Let's look at it another way: From 1962 to 1981, when the 10-year Treasury yield more than quadrupled, from 3.85 percent to 15.8 percent, the median cumulative return for actively managed, large-cap mutual funds was more than 62 percent better than the S&P 500 or an average of 3.2 percent per year. The lead reached 70 percent in 1983, and then steadily eroded as interest rates headed down over subsequent decades.

What's going on today?

Rates may have made a bottom shortly after the Brexit vote last June when the 10-year Treasury yield fell to 1.34 percent, and they have been rising, on the whole, ever since.

Meanwhile, 43 percent of active managers performed better than their indexes in the fourth quarter of 2016, according to Morningstar data, and 49 percent did so in January of this year. This is well ahead of the three-year average at the end of 2016, which was a dismal 10 percent. The recent trend has clearly improved for active managers.

Many analysts believe rates will increase at some point later this year, although knowing how much and for how long requires a crystal ball.

If they are right, at least 50 percent of active managers should outpace their benchmarks at some point in 2017.

Maybe it's time to think contrarian and buck the trend of money flowing out of actively managed funds into index funds. It may finally be the time for active managers to shine.

Not a believer? Understandable after the years of painful underperformance of active managers while the Fed worked to keep interest rates artificially low. But those days seem behind us. It looks to be the wrong time to fully abandon active managers.

Commentary by Debra Silversmith, the chief investment officer of First Western Trust.

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