Radioactive: Is Passive’s Dominance Over Active Set to Wane?

Key Points

  • Monetary policy, growth and inflation conspired to elevate correlations and passive’s outperformance over active
  • But the winds are shifting and regimes are changing; supporting a better environment for active management
  • A balance between the two strategies will likely serve investors best

One of the key themes I and my strategy colleagues highlighted in our 2017 outlook was the regime change from monetary policy being the only game in town to fiscal policy taking at least one of the reins. There are important implications of this shift—key among them is likely a shift from passive (index-oriented) investing strategies being rewarded with both strong performance and flows, to more active strategies garnering more flows and generating better returns. The latter have struggled throughout the current bull market. The usual inefficiencies seen in market pricing waned, making it more difficult for actively-managed funds to find an edge and outperform.

Passive has crushed active

In the double chart from Ned Davis Research (NDR) below you can see these trends. The top field shows the outperformance by passive ETFs relative to active mutual funds (23.5% vs. 9.2%, respectively, compared to the S&P’s 16% annualized return). The bottom field shows the significantly stronger in growth in passive assets relative to active assets.

AUM Growth and Stock Performance

Two performance cases in point

First, hedge funds—dominant in active strategies—have underperformed the S&P 500 every year since 2008, according to Strategas Research Partners. It's the longest stretch of underperformance in the history of hedge funds. Second, in the seven full years during this bull market—2010 through 2016—only one-third of U.S. large-cap growth active managers outperformed the Russell 1000 Growth Index, according to Morningstar data.