Rising rates, surging inflationary figures and geopolitical issues have plagued the broader markets all year. And with that, a variety of asset classes has continued to fall as investors seek safety in cash and short-term bonds. For index investors, the carnage has been widespread.
However, for active managed funds, the damage has been far more muted.
Thanks to their ability to shift through opportunities, flee to cash and not track an index, a variety of actively managed funds – particularly exchange traded funds (ETFs) – has managed to beat their benchmarks heading into the fourth quarter and end of the year. For investors in certain asset classes and sectors, active clearly remains the preferred choice for their portfolios.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
A Bad Year
No good deed goes unpunished – that axiom could be applied to the amount of stimulus enacted during the pandemic. With the post-COVID-19 snapback, inflation has surged as supply/demand constraints have hobbled the economy. To that end, the Federal Reserve has started to raise rates to combat inflation, which has sent a variety of sectors and assets lower. Add in a dose of geopolitical pressures as well as other factors and you have a recipe for poor performance.
All in all, the S&P 500 is down about 16% this year, while the Bloomberg US Aggregate Bond Index is down about 13%.
Those poor returns could be a problem for many investors. More and more investors – both big and small – have turned to index funds to build their portfolios. The proliferation of exchange traded funds (ETFs) have only exacerbated that trend further. Thanks to their low costs and ability to provide broad market access, ETFs and index funds have become necessary building blocks.
And historically that has been the right call, with passive funds generally beating active managers by a mile.
However, the current market environment perhaps is flipping the script. It turns out that active management in certain segments of the market could be the better call as rates of underperformance have continued to improve. A new study by S&P Global – popularly known as the SPIVA U.S. Scorecard, showed that large-cap active managers are having their best year since the Great Recession of 2009. The study showed that through the second quarter, around 49% of active large-cap managers have managed to outperform their benchmarks. While that may seem like poor a result, it is a vast improvement of the long-term average with just 32% of active large-cap managers outperforming.
Investment researcher Morningstar also produced a similar study that delves deeper into respective categories and fund styles. Here, the researcher found that several categories produced significant outperformance this year. These included mid-cap blend & growth, all manner of small-cap funds, large-cap growth and real estate.
Why the Wins?
So why has active management won out this year in some categories versus their passive benchmarks? The answer is two-fold.
The beauty of index investing is that you own everything. The problem with indexing is also that you own everything. In a market like today, that can be a big issue. Earnings misses, dips to revenues and poor guidance are punished severely by already-on-edge investors. And we’ve recently seen some very high-profile blowups. Because active managers can pick and choose what they own, they can avoid some of these misses and highly valued stocks. An additional point here is that some areas of the market are typically inefficient when it comes to focus and research. There are plenty of analysts and news stories that cover Apple. Not so in the small-cap space.
Also, index funds are forced to be fully invested. Not so with active management. Here, a manager can build cash, sell-off stocks as they see fit, lock in gains and avoid losses. This can help them in volatile environments like today versus their benchmarks.
There’s a third piece to the puzzle that active ETFs are helping turn the tide against active management’s chronic underperformance. And that is the cost. Historically, active funds have been significantly more expensive than their passive peers. That fee hurdle is one of the main reasons for their underperformance. But there is hope. According to Morningstar’s data, the cheapest funds in any category have typically been far more successful and performed better than higher priced ones. Looking at the 10 years through to June of 2022, the cheapest funds had a 32% success rate versus just 19% for the most expensive funds. Honing into more recent years, when active ETFs have taken off, and the success rate explodes for the cheapest funds.
Active & Passive Together Make Sense
Ultimately, the lesson from this year and the current market environment is that investors shouldn’t be so quick to pass off active funds and strictly be index investors. Clearly, there is value to be had in having both styles of management in a portfolio. Active can drive the show during periods of strife, while passive investing can win out during long periods of market upswings. The other thing to remember is that underperformance does not equal negative performance. In many instances, active managers still generated good returns. They were just less, and sometimes just slightly less, than their benchmarks.
Which brings us to the second point. Active ETFs and low-cost active funds are the way to go. Investors choosing to use both need to focus on the biggest bang for their buck. Choosing low-cost active ETFs is critical to making them work.
All in all, active funds are proving their worth this year. And investors should consider them as part of their allocation plans.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
