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.
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.