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Now is the time for active fund management

In years of rising stock markets and low volatility, passive investment management has certainly had its day in the sun.

But, my friends: with China slowing down, interest rates at zero and markets in a twist, today is not that day.


Data picking transparent screen
Triloks | Getty Images

Sure, the active/passive debate has been going full force for decades. And, in 2014, a year that proved particularly tough for active managers (only 10-20 percent beat their benchmarks), many more investors moved to embrace passive management.

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And clearly, passive investment via an ever-expanding assortment of exchange-traded funds can make a lot of sense in certain market environments. However, when we take a look back through decades of data, we find extended periods when the majority of active managers have outperformed their passive counterparts.

In times of rising interest rates, for example, there is a lower correlation and a higher dispersion between the best- and worst-performing stocks, an important factor for active managers. Or at times such as today, when entire industries may be getting their stock prices knocked hard by China fears, there can be a lot of room for expert analysis to reveal which companies have real exposure to China, and which ones don't.

In periods of high correlation, when a large percentage of stocks move up or down in tandem, active managers tend to get little reward for their fundamental research. Most recently, in 2009 the Federal Reserve began pumping liquidity into the economy to keep interest rates low. That had the added effect of pushing investors toward risk assets such as stocks. With the Fed's quantitative easing acting as a "safety net," we saw investors take on substantial levels of risk in the stock market. Within the major indexes, low quality companies with high levels of debt and poor or non-existent earnings outperformed their higher quality counterparts. This makes for a particularly difficult performance environment for most active managers who specifically use research to select high quality companies for investment.

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However, QE ended in October and rates have only one direction to go from here: up. And with a slowdown in China, we are seeing a shakeout.

Based on historical trends, this would be an environment that would likely favor active managers. In fact, we see that in a cyclical trend, active management beats passive management in a fairly regular periodicity. In our analysis, a majority of active managers outperformed their benchmarks in 11 calendar years since 1989. The latest include 2007, 2009 and 2013.

So, like many things in life, there is a time and place for everything. It is not either/or. And given where we are today, active managers might just earn their fees.

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