Active vs. passive choices are part of life, even when talking about investing.
Active portfolio management looks to pick stocks in an attempt to outperform the market. It pays particular attention to market and economic trends, with the potential for high returns. Passive management on the other hand, creates an allocation that attempts to mimic a specific index and generate a similar return. This approach isn’t proactive, and in turn, it’s typically associated with lower fees. With two tactics that are so different in their approach, it has led to an ongoing debate as to which is the better option. So what’s the answer? It depends on timing.
The growth of passive fund management
Over the past decade, passive management has grown in popularity. In 2016 alone, passive ETFs attracted $287 billion in new money. What’s caused this growth? Following the Great Recession, stocks steadily climbed with some financial analysts noting, “You could have thrown a dart at the market and whatever you hit did well.” This trend favored passive funds that mimicked indexes like the S&P 500, which had annualized returns of roughly 15 percent during this time. It’s hard to pick stocks that will outperform an index when almost all stocks are performing well. Solid returns, coupled with lowers fees, transparency, liquidity, and the emergence of robo advisors, has led many to cast their vote for passive funds in the great portfolio management debate.
But, according to Wall Street predictions, passive funds may not fare well with the market changes expected to occur soon.1
A potential bright future for active funds
Some suggest that political and economic changes may lead to heightened market volatility, and more ups and downs in the market are what active managers need in order to do their jobs. As market volatility increases, there’s more differentiation between stocks, giving active managers the ability to pick funds that can not only mitigate against loss, but also capitalize on stock market mispricing.2
You should also consider the age of our current bull market. Eight years in, this bull market is over extended and a bear market may be on the horizon. Actively managed portfolios are not locked into specific funds and have the ability to invest in defensive stocks during down years. Passive index funds, on the other hand, need to stay fully invested and may end up suffering significant loss during this type of market. And while active managers may not be hitting all of their benchmarks during the current bull market, over the last 20 years, top active managers have outperformed their benchmarks in down years.3
Additionally, rising interest rates may have a large impact on active fund management. Rates have continuously inched up since 2016 and are expected to climb through 2019. As rates rise, stocks and specific sectors become less correlated, presenting an important opportunity for stock pickers. Record low interest rates have hurt active managers. The three-year average for active managers outperforming their benchmarks at the end of 2016 was only 10 percent, but with rates rising at the end of 2016, outperformance was up to 49 percent at the end of January 2017. It’s easy to see that the recent interest rate increase trends have been an improvement for active managers and their success in meeting or beating their benchmarks.4
So which strategy wins the great portfolio management debate?
There may never be a clear winner in the active vs. passive portfolio management debate. It’s important for investors to have a mix of both while also taking current economic trends and predictions into account. Now may be a good time for strictly passive investors to consider the benefits of actively managed funds. Overall, political change, a looming bear market, and rising rates provide potential to both avoid loss and increase returns.