Download Four Myths in the Active/Passive Debate

MARKETVIEW
FourMythsintheActive/PassiveDebate
November7,2016
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Wetakeadeeperdiveintokeymisconceptionsaboutactiveinvesting.
Thereare,inourview,f ourmythsof tenrepeatedintheactive/passivedebate.
1)It’simpossibleforactivemanagerstobeatindexes.
Fiveyearsago,thiswouldhavebeenastrawmanargumentthatnoonewouldhavetaken
seriously.Butoverthepastf ewyears,someinvestorshaveembracedthisclaimasalegitimate
one.It’sbolsteredbyoverblownheadlinessuchastherecentoneintheFinancialTimes,which
statedthat“99%of activelymanagedU.S.equityf undsunderperf orm.”
Manyof theseheadlinestreatpassiveoutperf ormanceasaninevitability.Thetruthisthatpassive
strategiesareenjoyingaperiodof unprecedentedperf ormancerelativetoactivepeers.Chart1
showsthat,asof October31,2016,thethree-yearperf ormanceof theS&P500® Indexwould
rankinthetenthpercentileof theLipperLarge-CapBlendclassif ication,thestrongestrankingin25
years.
Chart1.IndexPerformanceisUnusuallyStrongRelativetoActiveManagers
S&P500rankinginLipperLarge-CapBlendclassification,rollingthree-yearperformance
Source:Lipper.Note:Rollingthree-yearperf ormancerankingstabulatedonanannualbasis;2016dataasof
10/31/2016.
Pastperformanceisnoguaranteeoffutureresults.Forillustrativepurposesonlyanddoesnotref lectanyspecif ic
portf oliomanagedbyLordAbbettoranyparticularinvestmentandshouldnotberelieduponasinvestmentadvice.
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Indexesareunmanaged,donotref lectdeductionof f eesandexpensesandarenotavailablef ordirectinvestment.
Af urtherlookatthestudiesunderlyingtheheadlinesshowssomeseriousf lawsinthe
methodology.Oneof thebiggestisthattheshareclassusedf oractiveperf ormancemeasurement
bytheS&PDowJonesinitsSPIVA[StandardPoor'sIndexVersusActive]studiesisthe“largest
shareclass.”Thatmostof tenisthe‘A’shareclass,whichtalliesdistributionchargesinits
managementf ees.Theclassisconstructedinthismannerbecausetheusersareof ten
commission-basedadvisors,onbehalf of theirclients.Thissetof advisorsdoesnotchargean
ongoingadvisoryf ee,andsoearnsalivingthroughsharesof otherf ees,someof whichare
containedinmutualf unds’managementf ees.Fee-basedadvisors,ontheotherhand,chargean
annualf eetomanagemoney,whichisnotincludedinthef unds’managementf eesandnot
deductedf romperf ormance.Comparingshareclassesbuiltf orcommission-basedadvisorswith
otherclassesbuiltf orf ee-basedadvisorsistocompareanetresulttoagrossresult.
Morecaref ullyconstructedstudiesdon’tgrabtheheadlinesliketheSPIVAstudiesdo,butthey
showmorerealisticresults—suchas,thatasmallmajorityof managersunderperf ormindexesand
somemanagersearnwellinexcessof theirf ees.Managersthatf ocusonactivestockpicking,f or
example,havebeenshowntoexhibitexcessreturnsof 1.4%,onaverage,asindicatedinresearch
byMartijnCremersandAnttiiPetajisto,intheirseminalpaperon“activeshare,”“HowActiveIs
YourFundManager?”
2)Passivefundsarealwayssignificantlycheaperthanactivefunds.
Inanothercaseof headlinenumbersnottellingthewholestory,theaveragemanagementf eeof
passivef undsissometimescomparedtotheaveragemanagementf eeof activef unds.
Morningstar,f orexample,f igurestheaverageactivef undf eeatabout80basispoints(bps)and
theaveragepassivef undf eeatabout20bps—adisparitythatisof tencitedtojustif ycapital
f lighttopassivestrategies.However,it’simportanttounderstandthattheseareasset-weighted
expenseratiosandthattheassetmixbetweenactiveandpassiveisquitedif f erentindif f erent
assetclassesandstyles.Thepassiveshareof theMorningstarLargeBlendcategory,f or
example,is71%,whiletheshareof theMorningstarLargeGrowthcategorythatispassively
managedisonly13%.Furthermore,whenpassivef undsdocompeteinspecializedsectors,the
managementf eeistypicallymuchhigherthananasset-weightedaverageof allpassivef ees.In
equityincome,f orexample,theaverageETF(exchange-tradedf und)managementf eeis47bps
whiletheaverageS&P500ETFisonly13bps,accordingtoLipper.
Inaddition,activemanagerscannotallbegroupedintoa“highcost”bucket,asthereareawide
rangeof f eestructuresavailable.Low-costactivef undscanbeacompellinginvestment
propositionwiththeopportunityf oralphaf romactivemanagementatcostscomparableto
competingpassivef unds.Morningstar’smostrecentActive/PassiveBarometerf oundthatthe
lowest-costquartileof activef undswaslikeliertosurvive,andenjoyedgreateroddsof success
(successbeingdef inedasbeatingpassivecompetitors)ineverycategoryversusthehighest-cost
quartile—andsometimesthedif f erencewasdramatic.Inmid-capvalue,f orexample,thelowest
expensequartileof activef undshada10timeshighersuccessratethanthehighestexpense
quartile.
3)Allequityallocationsaregoingpassive.
Theheadlinesalsosuggestmassivecapitaloutf lowsf romactivelymanagedequityf undsinto
passivestrategies.Whilethisdirectionallyistrue,themagnitudeisof tenoverstated.Atthevery
least,theimplicationsof thesecapitalf lowsshouldbeconsidered.
Ithasbeenwell-documentedthatinvestorstendtochaseperf ormance,andthat,historically,this
tendencyhasbeendetrimentaltoinvestorreturnswhencomparedtoasset-classreturns.Manyof
thedollarsf lowingintopassivelymanagedequitystrategiestodaymaybeperf ormance-drivenas
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well.Ourconcerniswhathappenswhentheperf ormanceandf lowsreverse.Arecentstudyf rom
DeutscheBankrevealedthattheaverageholdingperiodf orequityETFswasonly137days.
PassiveinvestorschoosingtheETFvehiclemaybeinvestingalongsideshort-termtradersand
otherswhoarechasing“hotmoney”thatcouldpotentiallyf leequicklyif perf ormancerankingswere
toreverttothehistoricalmean.Mutualf undinvestors,ontheotherhand,tendtoinvestf orthe
longterm,assupportedbyarecentICIstudythatreportedthat91%of mutualf undinvestors
statethatretirementisoneof theirinvestmentobjectives.
Finally,theheadlinenumbersdetailingthef lowsf romactivelymanagedequitiesoverlookacritical
distinction.Flowsareonlytrackedf ormutualf unds,andaredif f iculttotracef orless-transparent
vehicles,suchascollectiveinvestmenttrusts(CITs).Asadoptionof collectivetrustsbydef ined
contributionplansaccelerates,onlytheoutf lowsarecapturedwheninvestorstransf erf rom
activelymanagedmutualf undstoactivelymanagedCITs.IntheweekendedOctober26,f or
example,investorsredeemed$16.6billioninequityf unds,but$11.7billionof thatf igurewasdue
toarestructuringof anactivelymanagedproprietaryf undtoaCITstructure,accordingtoLipper’s
WeeklyFundFlowsInsightReport.
4)Activemanagementisazero-sumgame,mathematicallyforcingtheaverage
managertolosetolow-costindexes.
Mutualf undsrepresentonly24%of theownershipof U.S.equitiesand,despitetheassetgatheringbingeinthelastf ewyears,ETFsstillrepresentonlyabout5%of themarket(seeChart
2).Thismeansmutualf undscantradewithmanyothertypesof activeinvestors.Households,f or
example,arestill37%of themarket,withpensionf undsandinternationalinvestorsrepresenting
otherlarge,non-mutual-f undcohorts.Further,thereissubstantialevidencethatsomeportionsof
thisactivemarket,especiallyretailinvestors,underperf ormtheassetclassreturnssystematically.
Sowhileactivemanagementmaybeazero-sumgame,institutionalmanagerslikemutualf undsare
notrelegatedtomarketreturnsminusf ees,asissometimesargued.
Chart2.MutualFundsRepresentOnly24%oftheU.S.CorporateEquityOwnership
OwnershipofU.S.corporateequitymarket($36trillion),asofJune30,2016
Source:FederalReserveandGoldmanSachsGlobalInvestmentResearch.
Note:Dataasof June30,2016;markettotals$36trillion,whichincludes$7trillioninf oreignequityholdings.
Forillustrativepurposesonlyanddoesnotref lectanyspecif icportf oliomanagedbyLordAbbettoranyparticular
investmentandshouldnotberelieduponasinvestmentadvice.Indexesareunmanaged,donotref lectdeductionof
f eesandexpensesandarenotavailablef ordirectinvestment.
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Inthisliesanopportunityf orprof essionaladvisors.If itwereeasytopickanoutperf orming
manageratrandom,anyonecoulddoit,andalargeportionof anadvisor’sworthwouldbe
questionable.Fortunately,notallmanagersarethesame.Ittakessomeknowledge,some
quantitativeandqualitativeresearch,and,indeed,someskilltochoosethosewhowilloutperf orm
goingf orward.Aprudentinvestorwilllookf ormanagerswithacommitmenttoinvestmentresearch,
along-termrecordof perf ormancethroughavarietyof marketconditions,investmentandriskcontrolprocessesthatarerepeatableandsound,and,of course,reasonablef ees.
RiskstoConsider:Thevalueof investmentsinequitysecuritieswillf luctuateinresponsetogeneraleconomic
conditionsandtochangesintheprospectsof particularcompaniesand/orsectorsintheeconomy.Historically
speaking,growthandvalueinvestmentstendtoreactdif f erentlyduringtheeconomiccycle.Sincevaluestocksare
of tencyclicalinnature,theymaybenef itf romtheincreasedspendingthatusuallyoccursduringaneconomic
expansion.Growthstocksmayalsoperf ormwellduringanexpansion,buttheymayalsobeoutof f avorduringmarket
downturns,wheninvestorspaymoreattentiontopriceratios.Whilegrowthstocksaresubjecttothedailyupsand
downsof thestockmarket,theirlong-termpotentialaswellastheirvolatilitycanbesubstantial.Noinvestingstrategy
canovercomeallmarketvolatilityorguaranteef utureresults.
Note:Statementsconcerningf inancialmarkettrendsarebasedoncurrentmarketconditions,whichwillf luctuate.
Thereisnoguaranteethatmarketswillperf orminasimilarmannerundersimilarconditionsinthef uture.
LipperLarge-CapBlendportf oliosareFundsthat,byportf oliopractice,investatleast75%of theirequityassetsin
companieswithmarketcapitalizations(onathree-yearweightedbasis)aboveLipper’sUSDElarge-capf loor.Largecapcoref undshavemorelatitudeinthecompaniesinwhichtheyinvest.Thesef undstypicallyhaveaverage
characteristicscomparedtotheS&P500Index.
MorningstarLargeBlendportf oliosaref airlyrepresentativeof theoverallU.S.stockmarketinsize,growthrates,
andprice.Stocksinthetop70%of thecapitalizationof theU.S.equitymarketaredef inedaslargecap.Theblend
styleisassignedtoportf olioswhereneithergrowthnorvaluecharacteristicspredominate.Theseportf oliostendto
investacrossthespectrumof U.S.industries,andowingtotheirbroadexposure,theportf olios’returnsaref oten
similartothoseof theS&P500Index.MorningstarLarge-Growthportf oliosinvestprimarilyinbigU.S.companiesthat
areprojectedtogrowf asterthanotherlarge-capstocks.Stocksinthetop70%of thecapitalizationof theU.S.
equitymarketaredef inedaslargecap.Growthisdef inesbasedonf astgrowth(highgrowthratesf orearnings,
sales,bookvalue,andcashf low)andhighvaluations(highpriceratiosandlowdividendyields).Mostof these
portf oliosf ocusoncompaniesinrapidlyexpandingindustries.
MorningstarLargeGrowthportf oliosinvestprimarilyinbigU.S.companiesthatareprojectedtogrowf asterthan
otherlarge-capstocks.Stocksinthetop70%of thecapitalizationof theU.S.equitymarketaredef inedaslargecap.
Growthisdef inesbasedonf astgrowth(highgrowthratesf orearnings,sales,bookvalue,andcashf low)andhigh
valuations(highpriceratiosandlowdividendyields).Mostof theseportf oliosf ocusoncompaniesinrapidlyexpanding
industries.
TheS&P500 ® Indexiswidelyregardedasthestandardf ormeasuringlargecapU.S.stockmarketperf ormanceand
includesarepresentativesampleof leadingcompaniesinleadingindustries.
TheopinionsinMarketViewareasof thedateof publication,aresubjecttochangebasedonsubsequent
developments,andmaynotref lecttheviewsof thef irmasawhole.Thematerialisnotintendedtoberelieduponas
af orecast,research,orinvestmentadvice,isnotarecommendationorof f ertobuyorsellanysecuritiesortoadopt
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anyinvestmentstrategy,andisnotintendedtopredictordepicttheperf ormanceof anyinvestment.Readersshould
notassumethatinvestmentsincompanies,securities,sectors,and/ormarketsdescribedwereorwillbeprof itable.
Investinginvolvesrisk,includingpossiblelossof principal.Thisdocumentispreparedbasedontheinf ormationLord
Abbettdeemsreliable;however,LordAbbettdoesnotwarranttheaccuracyandcompletenessof theinf ormation.
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