Active fund managers have their chance at long last

Market volatility and US economic uncertainty will buoy the managers

Macro and market conditions should favour stock-picking "active" management over index-tracking "passive" investment. Bryan Smith/AFP

After years of struggling to beat the index, 2018 should be the year active fund managers earn their spurs.

Market volatility will finally pick up from record low levels, US economic uncertainty will deepen as the expansion becomes the longest in history and the Fed shrinks its balance sheet, and the prospect of at least a 10 per cent drawdown finally hitting stocks will increase.

If that's how 2018 plays out - not an unreasonable scenario - macro and market conditions should favour stock-picking "active" management over index-tracking "passive" investment.

At least, that's the theory. And it does look like actively managed funds had a pretty decent 2017, certainly relative to their chequered recent past.

According to MorningStar, active funds' success increased "substantially" in 10 of the 12 categories it tracked in the year ended June 30 compared with the same period a year ago.

About 49 per cent of active US stock funds beat their composite passive benchmark in the 12-month period ended June 30, 2017, versus 26 per cent for the year ended Dec. 31, 2016, MorningStar said.

The latest findings from S&P Dow Jones Indices show a similar direction of travel. In the 12 months to June this year, 57 per cent of large-cap managers, 61 per cent of mid-cap managers and 60 per cent of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively.

That doesn't sound great. But it's a clear improvement on the last five years when 82 per cent of large-cap managers, 87 per cent of mid-cap managers and 94 pe rcent of small-cap managers all underperformed their respective benchmarks.

Over the last 15 years the scale of underperformance is even greater: 93 per cent, 94 per cent and 94 per cent, respectively. That 15-year span includes two of the biggest drawdowns in Wall Street history in 2002 and 2008, two periods when index-tracking funds beat the active fund manager, S&P Dow Jones Indices figures show.

History shows it's hard to beat the market, even in times of high volatility, steep market drawdowns, whirling sector rotation and wide price dispersion.

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"The belief that bear markets favour active management is a myth," S&P Dow Jones Indices wrote after the 2008 crash.

This year has been the polar opposite. Implied volatility, as measured by the VIX index, was its lowest since the index was created in 1990, and realized volatility, as measured by the number of trading days with an intraday swing of less than 1 per cent was its lowest ever.

The S&P 500 hit dozens of fresh record highs this year and is on course for an annual rise of 20 per cent. Will market conditions be so benign next year?

A survey of 500 institutional investors released this month by Natixis Investment Managers found that active management will be a better bet than passive strategies because market conditions will be more volatile.

As the risk of asset bubbles bursting next year rises, 76 per cent of those surveyed said 2018 will favour active management.

Extraordinarily low volatility this year is partly a consequence of huge inflows into index funds and exchange-traded funds, the survey suggested. Some 59 per cent of respondents said low volatility is a cause for serious concern and 63 per cent said the growth of passive investing has contributed to the sharp rise in valuations.

However, another recent survey by consultancy EY showed that the rapid rate of growth across passive investing shows no sign of slowing. Admittedly, this was a survey of ETF market makers, but the results were still revealing.

The survey, which covered ETF market makers who collectively manage around 85 per cent of global ETF assets, suggests assets in passive investment funds will exceed active funds within 10 years.

The ETF market is on track to swell to US$7.6 trillion by the end of 2020 from just under $5tn currently, it found.

In order to keep the cash flowing in, ETF fees, which averaged just 27 basis points last year, will have to keep falling. Being a low-cost provider is a "prerequisite to survival", the EY survey found.

A report by financial services firm bfinance earlier this year showed that active fund management fees are also falling, with the average fee quoted by global equity managers now around 57 basis points compared with 62 basis points in 2015.

But, that's around double the average passive fund fee investors are paying for what is, on average, a worse performance.