Is it Time for Active Management Equity Funds? Nope.

In the most recent bull market, some passive equity investments outperformed actively managed equity funds, questioning whether the higher fees of active management were worth it. The question came into sharp focus in the fall of 2019 when assets of U.S. index-based equity mutual funds and ETFs surpassed actively managed funds for the first time. Now in 2020 with the volatility of markets due to Covid-19, active managers have been given the opportunity to show their worth, to prove that they can outperform their benchmarks in periods of market turbulence and downturns.

But, new research by S&P Dow Jones Indices shows many still underperformed in the first four months of 2020. S&P Dow Jones Indices publishes two scorecards each year, reporting how active managers performed compared with their benchmarks. Given the record volatility in markets since Covid-19, they published a shortened version of their scorecard to see how active managers fared during the market downturn in March and the recovery in April.

They found that 64% of U.S. equity funds underperformed the S&P Composite 1500 (which combines the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600) in the first four months of the year. 67% of these funds underperformed in the past two quarters. Active managers of large-cap funds fared the worst. In the first quarter of 2020, 54% of large-cap funds underperformed. In April, when markets rebounded, the percentage of large-cap funds that underperformed for the entire year increased to 59%.

Why are active managers underperforming? There are many possible reasons. Almost 30 years ago, Nobel Prize winning economist William F. Sharpe in an article published in The Financial Analysts’ Journal, titled “The Arithmetic of Active Management”, where he explained that with “active” and “passive” managers investing in the market, the aggregate performance of the active managers must equal the passive manager’s performance, minus the difference in fees. This is because before fees, passive managers, by definition, will hold a pro-rata slice of all securities in the market and thus obtain the same return of the market itself.

Another possible reason is some active managers are still doing “closet-indexing” or investing in securities too close or similar to the benchmark. But what about the active managers that are moving to more concentrated portfolios, i.e., becoming less tied to an index? Well, this works when they bet on the right securities, but if they are wrong?

The latest brief period when active funds appeared to be beating the market stopped in mid-2019. This coincided with the end of dramatic outperformance by the “FAANGs” — Facebook, Amazon, Apple, Netflix and Google (now Alphabet). Active funds that included these stocks early in the stocks’ run up and held them performed well, until they didn’t.

More recently Covid-19 is showing a select few stocks are performing well while others are struggling. This means market breadth has narrowed since the pandemic. A May 22nd article in Barron’s points out that the NASDAQ Composite, which tracks more than 3,000 stocks, is the poster child for narrow market breadth. According to the article, the index’s 10 largest stocks by market cap are all tech stocks and they are dominating the index, pushing the composite up nearly 4% year to date through May 22nd. However, the typical NASDAQ stock is down nearly 19% during this same timeframe.

Some active managers have the challenge of picking the tiny number of stocks that perform well. This is a challenging task regardless of whether it’s a good or bad market environment.

While active managers may say they are more agile in responding to market downturns and have more flexibility to invest in cash instead of securities, the S&P Dow Jones Indices data shows this may not be the case. This is no surprise to us. It is fool’s gold. No one is able to reliably and consistently over the long term call the bottom or top of the markets. The sudden end of the longest bull market and the uniqueness of this global pandemic make it difficult for active managers and investors to look at historical bear market data or other data points and have clear sight into the future.

There clearly are asset classes that benefit from active management, such as fixed income funds. Having the ability to move the duration and types of fixed income products has been proven to be beneficial as opposed to index funds that by definition lack the capacity to do so.

The volatility in the markets reflects the uncertainty of identifying the end to this health crisis and the extent that businesses and economies will be able to fully open. Investors should continue to focus on the long term, not the next 3- to 6-months. If your long-term view has changed significantly then consider making adjustments to your portfolio. We continue to believe investing in low-cost, passive funds remains the soundest long-term investment.