Is the Role of the Active Manager Obsolete?

Is the Role of the Active Manager Obsolete?

August 27, 2018

By Mike Moreland • Vice President Investments

Two of the investment phenomena of the last decade are the dramatic growth of indexing and the failure of most active managers to match the returns of a cheap, simple index fund.  Clearly, these are related.  Success followed success; what started as a low-cost way to invest became mainstream as more dollars flowed to the products, which in turn drove higher the prices of their primary components.  A ‘virtuous circle’ of superior relative performance ensued.  So how did we get here?

Since most indices are capitalization-weighted, the biggest companies tend to pull the index away from the rest of the pack.  Active managers, emphasizing a broader universe and paying attention to value and opportunity, found themselves building strong, well-diversified portfolios that trailed the returns of mechanistic programs built to replicate an index, often dominated by a handful of issues (think of the impact of the FAANG stocks -- Facebook, Apple, Amazon, Netflix, and Google (Alphabet) -- on the S&P 500).  Why bother with fundamental analysis when one can buy Amazon (at 150 times estimated earnings) and enjoy riding the wave? 

Is the battle over and active management consigned to the trash heap of financial history?  Not by a long shot.  Consider the environment in which indexing reached its present stage.  All of the major influences on equity management encouraged a simplistic approach. 

  •  Low interest rates over the last decade pushed investors toward risk assets to earn a positive return.  Index investing provided an easy mechanism to do so.  Vanguard should send a nice holiday basket to the Federal Reserve. 
  • Correlations were high; the rising tide lifted all boats.  Why pay extra for active management when the range of outcomes for most markets was narrow?  Just buy the index and guarantee a market return. 
  • Volatility was almost non-existent, with 2017 recording the lowest intraday market changes in a generation.  The risk protection offered by value-conscious, diversified active management was not needed; no reason to pay for low perceived value. 
  • A broader reason is the information revolution. There are fewer pockets of undiscovered opportunity than in the past.  Performance versus a benchmark is increasingly due to allocation decisions, not security selection.  Index representation is often the cheapest and easiest way to express an opinion on a market sector. 

Most contributors to the ascension of indexing are cyclical in nature, and the cycle is moving on.  The Federal Reserve is ending a decade of accommodative policies.  Volatility is rising.  Correlations are falling; market and sector returns are more idiosyncratic.  The environment is changing -- to the benefit of active management.

We’re firm believers in the long term benefits of active management, not only from return potential, but equally important from the perspective of risk control.  We use indexed products where they are most efficient, but rely on active management where the opportunities to add value are the greatest. 

This philosophy has enabled us, by and large, to live up to our commitment to clients:  we manage portfolios to keep up in the good markets and preserve capital in more challenging times. Contact an advisor and we can review how this works for you. 

About the Author

Michael Moreland

Mike Moreland is an advisor to the Wealth Management division, and former Vice President of Investment Services at Security National Bank. With more than 45 years of Wealth Management experience, along with his Sioux City roots, Mike has a rich background in finance and Siouxland.