Over the past number of years, we have seen a significant shift away from active investment management into index-tracking, passive management. Like nearly everything in the capital markets, I believe this too is cyclical.
One of the biggest reasons for the shift to passive strategies has been that a startling number of equity fund managers have underperformed their benchmarks. Now the problem with many of these funds is that they tend to look too much like their benchmarks and therefore have a hard time outperforming after fees. These “closet indexers” will be forced to become active or will face further outflows as investors become increasingly aware of this issue.
An opportunity that the passive management trend has presented is in small to mid-sized companies. Active management is effective in this space as many of these companies are not represented in the largest index funds so they haven’t seen the inflow of capital pushing prices up. Truly active, nimble managers (at least those with average skill) ought to outperform by investing in this neglected space.
An overlooked benefit of active management is that it should make the ride less emotional and make it easier for investors to stay invested for the long-term, resulting in better long-term returns. In an attempt to weed out the garbage in the market and only invest in companies offering good value, active management can provide some protection when the market corrects. When buying the index, you buy all that garbage along with the good.
On a theoretical note, the reason index investing became popular in the first place was the Efficient Market Hypothesis (EMH), developed in the 1960s by University of Chicago professor of economics, Eugene Fama. It states that all information is immediately reflected in the market and therefore it is impossible to capitalize on mispriced securities with any degree of regularity.
But what happens when a significant number of investors believe in the EMH and are no longer buying and selling companies based on information? I would suggest it leads to inefficient markets (more mispricings) and should reward true active managers willing to do the work.
As of December 2016, US fund investors held a record 36.22% in passive strategies. That’s a heck of a lot of people blindly investing in companies without any consideration for the price, the company’s business, financial strength or management teams.
At ZLC Wealth, we believe in contrarian investing and not following the herd. Right now, the herd is running strong with passive management
–Tom Suggitt, CFA, CFP, FCSI
Vice President & Portfolio Manager