Radioactive II: Could the Tide Finally Be Turning for Active vs. Passive?

Key Points

  • Both active and passive management styles have a home in investors' portfolios.
  • Passive continues to outperform active, but we may have seen the inflection point.
  • Plunging correlations and wider sector dispersion both bode well for active styles.

I'm often asked how I invest my own money and often imbedded in the question is whether I prefer active or passive investing strategies. My answer is always both, and at Schwab we generally believe investors can benefit from traditional active management; e.g. mutual funds; alongside newer passive vehicles; e.g. exchange-traded funds (ETFs). But even before the creation of ETFs there were debates about the merits of passive vs. active. I wrote about this topic in February, but it's time for an update. In addition, my colleague Tony Davidow recently penned an article in which he answers the oft-asked question, "Are ETFs Dangerous?"

The primary advantages of passive investing are low fees, tax efficiency and transparency; but by definition, passive funds will never beat the indexes they track. The primary advantages of active investing are flexibility, the ability to benefit from strong security selection skills, and tax management strategies; but fees are higher and poorly-managed funds can and often do underperform their benchmarks. Blending the two is another way investors can be diversified within their portfolios.

Active underperformance

As of mid-year 2017, more than one-third of all assets in the United States are invested passively—up from one-fifth ten years ago. Last year, S&P Dow Jones Indices conducted a study, and found that about 90% of active equity managers underperformed their benchmarks over the prior one-, five- and 10-year periods; with fees explaining a significant portion of that underperformance. But many active manager counter that the environment since the financial crisis has been unique in that correlations between stocks and the indexes in which they’re housed have been exceptionally high. That is until recently.

Plunging correlations

For those investors who continue to take an active approach to at least a portion of their portfolios, there is potentially some good news. Let’s start with correlations. As you can see in the chart below—which shows a one-year (trading days) rolling correlation of stocks within the S&P 500 to the S&P 500 Index itself—the correlation has broken down sharply. In other words, stocks are no longer displaying lemming-like behavior.

252 day correlation

Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2017© Ned Davis Research, Inc. All rights reserved.) As of August 25, 2017. Bear markets represent declines of 20% or more by the S&P 500.