The tide has turned: Active outpacing passive investing

• If the Big Six large-cap stocks leading the bull market stumble, a difficult market — the kind where active managers do best— could ensue.
• Passive management's fixation on the S&P 500 will continue to provide increased opportunities for active managers seeking value opportunities among lower large-cap companies.
• The more crowded that ETFs get, the more inclined well-informed risk-averse investors might be to shift money into active funds.

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Active investing's potential for superior performance tends to be higher in difficult markets.

In the perennial race between active and passive investment management, there are signs of a shift. After several years of bringing up the rear, active performance has outpaced passive so far in 2017. Various factors suggest that it could stay out front for a few years.

This year has been the best for active fund performance since the bull market began, as it has bested passive more than half the time. About 54 percent of active managers have beaten their benchmarks overall so far in 2017; about 60 percent did so in July.

Meanwhile, though long-depressed inflows into active funds have shown new life recently (they had their best week in 30 months in July, taking in $3.5 billion), money keeps gushing into exchange-traded funds. (Vanguard investors in index funds and ETFs now own nearly 5 percent of the S&P 500.) Real dominance by active management would be marked by a reversal of this tide.

This won't happen, of course, until after active management has shown a sustained performance advantage.

Various considerations suggest the potential for this, including:

Past trends. Historically, active management's comebacks have been multiyear rather than single-year. Though passive has reigned supreme over the past six years, active won the race for six years in the 1990s and from 2001 to 2011. Just as passive management has done best in up markets, active's potential for superior performance tends to be higher in difficult markets. Thus, active did well in the difficult market of the mid-1990s, and passive took the lead during the tech boom late in that decade.

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Today's narrow bull market. When the bull's starting point is pegged to the ascent that followed the financial crisis of 2008, the current bull market is now nine years old, the longest since World War II (though the argument could be made that this bull is actually of shorter duration because the market didn't hit a new high until 2013). Regardless, those anticipating a new market cycle are more likely to be gratified with each passing month, as the price/earnings ratio of dominant names have risen to ethereal heights.

This market has a weakness that isn't acknowledged widely enough: It's being driven mainly by six large-cap stocks — Facebook, Apple, Amazon, Microsoft, Google and Johnson & Johnson (the Big Six.) When the market has gone up in the past couple years, much of the gain has been because one or more of these stocks has appreciated. As of early September, year to date, all of the stocks have had robust double-digit gains, with Facebook's shares appreciating nearly 48 percent and Apple's about 37 percent.

If these few bulls stop running and the herd doesn't find new leaders, this result could be an ensuing difficult market — the kind where active managers do best.

Increasing opportunities for contrarian managers. With huge investment from index funds and ETFs, the Big Six have amassed a collective market capitalization of $3.4 trillion — greater than the total value of the bottom 1,115 stocks in the S&P 1,500 — the lower large-cap companies. If the Big Six falter, money pouring into them will presumably find other places to go.

But even if this happens, empowering the bull market to continue, passive management's fixation on the S&P 500 will continue to provide increased opportunities for active managers seeking value opportunities among lower large-cap companies. And some of these 1,115 orphans are fairly attractive.

Value indexes are flat, keeping the share prices of these stocks low. The market will be far different if value managers begin to shine by putting points on the board with lower large-cap stocks — and with mid- and small-cap names, where there may be even greater value opportunities — rekindling the allure for active management in general.

To the value-minded, the huge inflows into passive vehicles create opportunity for the Graham and Dodd set — Warren Buffett and his ilk, who are willing to wait for good returns after buying cheap.

The aversion to settling for average. In providing the returns of the overall market, passive management provides average performance (though a nice average in upward markets). In the Indy 500, this would mean a car finishing 11th out of 33 every year, curiously getting more prominent headlines because its owner spent less than those of the top-placing cars.

Sure, the name of the game is net returns. But finishing higher is the primary goal many investors. A key reason that active management won't go away is that these investors are willing to spend more to seek better-than-average performance. And if they choose the sharpest managers, they reason, they can get good gains net of costs.

Underestimation of the market risks of ETFs. These investments are widely touted as superior passive funds because, unlike index funds, investors don't have to wait until the end of the trading day to buy or sell them. This leads to the assumption that ETFs' intraday trading risks aren't any greater than those for stocks. But this assumption is faulty, as many passive investors painfully learned in the flash crash of Aug. 24, 2015.

On that day, amid concerns about China, extreme volatility struck blue chips, triggering more than 1,200 automatic halts to trading. This had a dunning effect on pricing of many ETFs, which typically trade in line with their net asset values — but not that day. At one point, some ETFs lost up to 40 percent of their value.

This is an object lesson on what happens when too many investors try to pile out (or in) the door at the same time. Some get trampled. The more crowded that ETFs get, the more inclined some well-informed risk-averse investors might be to shift money into active funds.

These points hardly support an argument for passive investors to switch their entire portfolios to active management. Indeed, a dual active-passive strategy can be a smart way to get the best of both worlds. Nevertheless, these considerations, along with the resurgence of active performance this year, might serve as strategic wake-up call for some passive investors as money continues to roar into ETFs.

— By David Sheaff Gilreath, partner and founder of Sheaff Brock Investment Advisors