Active vs. Passive Equity

Introduction: One of the most difficult philosophical questions to consider in the traditional equity markets is whether to use “active” or “passive” management. While outperforming the index in efficient market segments can be challenging for active managers, there are market environments in which they should be able to add alpha over their benchmarks. There is an inherent momentum bias built into market capitalization-weighted indices that makes it difficult to beat an index when markets are steadily rising, and explains why active management does much better when markets are falling. For example, technology stocks dominated the equity indices just before the Tech bubble burst in 2000.

Using the methodology described at the end of this article, we evaluated how managers have historically performed in different market return environments and considered other compelling quantitative and qualitative evidence for and against active management, including the cyclicality of active management and the inefficiencies of the broad and less-covered small cap and international equity markets. Our analysis suggests that, during periods of muted returns, both positive and negative, active managers should add value across the domestic and international equity markets, but historically have struggled in strongly upward trending markets, similar to what we have seen in recent years.

What is Passive Management? What is Active Management?
“Passive” management (also widely known as indexing) refers to investing in a broadly diversified market proxy, such as the Russell 2000 Index or MSCI EAFE Index, with no attempt to select individual securities that will outperform the proxy. The emphasis is on market participation, or beta exposure, with minimal tracking error. The management fees for these types of strategies are usually significantly lower than the fees charged by active managers. Since there is no team researching individual stocks and making allocation decisions, the organizational or “key man” risk also is reduced greatly. “Active” management refers to strategies that attempt to build portfolios by identifying securities of companies that exhibit attractive traits (e.g., financial strength, valuation, or cash flow) that should result in above-market returns.  Active managers seek to exploit inefficiencies that exist in market prices, partially due to information flow.  Active managers also have the ability to shift holdings from different sectors or regions when the managers believe economic and political situations make the shifts advantageous.  International active managers also are able to diversify currency risks.

U.S. Large Cap Equity

Over the past two decades, there has not been a defining trend to make the long-term choice between active or passive management easy. Recent years have brought a very challenging market for active large cap managers. The fourth quarter of 2016 was the first time since the fourth quarter of 2011 where the rolling three-year annualized return for the fee-adjusted indices shown in Table 1 fell below 10%.

The greater the market returns, the more difficulty active managers have in adding value over the benchmark. As shown in Table 1, for the core and style benchmarks in large cap, there were no periods when more than half of the active managers outperformed the benchmark when the annualized market return exceeded 20%. The historical track record for active management is very poor when the market rises more than 10% annually over three years, which has been the case for the Russell 1000 Index in 20 out of the previous 21 rolling three year quarterly observations, through the fourth quarter of 2016. When the three-year annualized market return is 5% or lower, the benchmark almost always ranks in the lower half of the universe across all three styles, though core managers have a more difficult time. When equity markets are negative on a rolling-three year basis, active large cap managers are more adept at protecting capital for the Core, Growth and Value styles.

U.S. Small Cap Equity

The small cap market has a much larger universe of companies than the large cap market. The small cap market appears to display substantial inefficiencies, facilitated by less Wall Street analyst coverage. These differences historically have enabled diligent small cap managers to gain an information edge, leading to better than benchmark risk/return characteristics.

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Inquiries or comments concerning this article may be addressed to:

Lori Wallace
Research Director
Pavilion Advisory Group Inc.

Nancy Rohde, CFA
Research Director
Pavilion Advisory Group Inc.


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