Time for Active to Shine?

Friday, July 18, 2014 |

Picking active managers isn't easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

For at least a decade now passive management (managers who attempt to mimic an index) has been all the rage. Originally passive management advocates were only on posters in Tiger Beat, but now they are on the cover of Vanity Fair. More and more we get research, white papers, even client calls extolling the virtue of passive management over their active counterparts (managers who attempt to beat an index). The trend continues to move more and more toward passive managers. Will this ever change?

No, at least not forever, and I am a big advocate of passive management. The reason was highlighted to me in the article.* Thesis: the trend will continue to move as millennials, who are skeptical of active management, migrate to passive managers and the older active managers, who make up the bulk of active management, retire leaving new managers with little track record.

But the reason the trend will eventually reverse is the same reason why the money ultimately started flowing that way – returns:

1. Active management became popular in the 80s as ways to get diversified* market exposure and good rates of return

2. As it gained in more popularity, more managers entered the field = lower % of managers beating their respective index as quality erodes. 

3. Many of these managers raised their fees given the increased demand, lessening their chance to beat the benchmark

4. So here comes passive managers, cheaper and better performing than active managers

5. Repeat steps 2 and 3 AND lower quality active managers leave the field as dollars move to passive AND if everyone is buying an index stocks will naturally become over and undervalued, creating a nice situation for active managers AND creates a self-reinforcing problem - during a market selloff who is buying if everyone is passive? This is where we are at.

6. The small pool of high quality active managers who were probably in cash before the sell-off and may now be well positioned to outperform over the full market cycle

7. Start over again

The debate of for academics, but why does this trend matter to retail investors? Opportunity. With everyone moving towards passive management, quality active managers should be better situated to beat an index over a full market cycle. Picking active managers isn’t easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.