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A new chapter in the Active v Passive debate

For financial professionals only

For years the challenge to Active managers has been that they don’t consistently outperform Passive funds enough to justify their relatively higher fees. In the record bull run, this was probably a fair observation. But is the tide starting to turn?

A rising tide lifts all ships

With loose monetary policy inflating markets indiscriminately, it was hard for stock-pickers to find significant outperformers. The chart below shows the US as an example, and how from 2009-2019 the IA sector struggled versus the corresponding FTSE index.

Recent volatility in markets and the sudden interruption to earnings caused by global lockdowns has sparked greater dispersion in the performance of both underlying sectors and the businesses operating in them.

Staying in the US, the chart below shows the same 10-year period but with the last 6 months added on, and a focus on the retailer, software, travel, and banking industries.

While banks have lagged the other three over the long term, broadly the trend for each has been upward. When uncertainty around trade wars kicked in through 2018-19 we saw some divergence, but the spread of potential performance shown year-to-date is a notable shift.

The change is easily explained if we think about our own behaviour over the past 6 months.

Global lockdowns have hit the travel and hospitality sectors hard, while a move to online living and working has bolstered technology solutions and e-commerce providers.

With concerns about the long-term impact on economies, and the ability for people to cover mortgage payments and other debts, it’s natural for some financials to take a hit. Renewed expectation of lower rates for longer leaves little for the banking sector to be positive about.

But why does this matter when you’re considering investment management styles?

Pick’n’mix

With an increased range between the worst performing and best performing stocks, Active managers have the advantage of being able to select which companies they buy or continue to hold.

Passive managers don’t have this luxury. They replicate the index, so they’re forced buyers of the underlying businesses within that index – whether they expect them to go up or down.

Not only that, but the proportion in which those funds are held is dictated by the index.

Active managers, on the other hand, can decide how much exposure they want to have to each company based on how they think they will perform in future. When the market fell in Q1, Active managers had the opportunity to buy into or top up businesses they believe in over the longer term. As those businesses bounce back, the Active funds will enjoy significant upside.

Active or Passive?

So, is time up for Passive managers? Active managers have certainly had the chance to earn their keep with recent market moves, and time will tell how effective they’ve been.

Now more than ever, the importance of a thorough due diligence process is showing its merit. Those managers with a focus on risk, as well as return, will have been better placed to navigate the recent downturn.

The risk for an Active management resurgence is that renewed central bank stimulus may again inflate markets, and Active managers will find themselves once again working in smaller margins.

But would another wave of liquidity have the same impact on markets now as it did 10 years ago? That remains to be seen.



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