The case for active asset management

The shift of money from active to index funds seems decisive proof of investors’ belief in the superiority of passive investing. According to Broadridge, the financial data provider, nearly $2.4 trillion has flowed into passive ETFs in the US over the last 15 years, while $500 billion has flowed out of active funds. But seemingly unstoppable investment trends have a habit of reversing unexpectedly.
Our research suggests that investors should keep an open mind:
• Some of the data overstates the case for passive
• It is wrong to extrapolate from the US that the index is hard to beat in all markets
• Passively replicating many bond market indices is almost impossible.
• Active management needs to be judged over lengthy time periods.
We also find that some of the benefits of active management have been overlooked. Active managers:
• Hold companies to account
• Help to direct capital into faster-growing industries
• Work to improve standards of governance and make businesses more sustainable.
The classic academic view of active management was proposed by Professor William Sharpe, who argued that, “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”. In reaching this conclusion, he assumed that the index represented the entire range of investment opportunities, and that all participants were motivated by the same objectives.
Since Sharpe many researchers have demonstrated that markets are less efficient than once thought, and that investors’ behavioural biases create opportunities for arbitrage by active managers. Moreover, not all investors necessarily want to beat the market. Hedge funds, for example, aim to generate strong absolute returns. Central banks manage the supply of money by investing in bond markets, while governments that own stakes in companies may seek to maintain employment or control natural monopolies.
This extends to individual savers and pensioners, many of whom seek an outcome that meets a savings goal or enhances their income before or during retirement. For these investors, success is likely to depend on allocating to the right asset classes. This cannot be done passively. There is no index that can be aligned with a real world outcome such as inflation plus 4%.
We have written before about the inadequacies of a purely passive approach to asset allocation. Dynamic asset allocation can make for better outcomes. It may be enhanced by the greater use of ETFs as tools for trading in and out of markets. Nonetheless, it is an active skill and cannot be replicated cheaply.
A newer dimension in the active/passive debate is factor investing (or smart beta). Such rules-based strategies have tended to outperform market capitalisation- weighted indices over most past periods. Not only has factor investing outperformed the indices most passive funds use (Figure 1), it has delivered excess returns more cheaply than traditional active management.

Passive reality looks less rosy
Much of the data used to demonstrate the weakness of active management comes from US equities. We accept that the indices in large cap US equities have been hard to beat consistently, but it is wrong to extrapolate this conclusion to other markets. This becomes clear when the real experience of an investor in non-US markets is investigated.
It is often assumed that the performance a passive investor experiences is equivalent to that of the market index. In reality, indices suffer neither trading nor management costs. A more realistic comparison is with the performance of passive funds themselves, such as ETFs, that bear real management fees and trading costs. Conducting such an exercise, as we have done in Figure 2, suggests that in many markets the argument that most active funds underperform is far from clear cut. The bottom row of Figure 2 shows the percentage of funds that have outperformed respective ETFs in the 5-year period. In calculating the percentages, we have included the performance of closed and opened funds.
Looking at this more closely, we focused on two equity sectors, UK and emerging markets, to show how active performance has varied over time. We looked at monthly excess returns, net of fees -in this case against the index. Unlike previous studies, we included only funds that are benchmarked to a broad index. By doing so, we excluded the funds that are either not benchmarked, or funds that employ a specific strategy, such as ESG or special situations. Figures 3 and 4 display the percentage of active funds that have outperformed their benchmarks on a rolling five-year basis. We acknowledge that these numbers include survivorship bias since only funds that have a full five years of performance history at a given date were included in the calculation.
Data from the UK (Figure 3) shows that the performance of active managers is cyclical, but that there have been several periods, including the present, when well over 60% of active funds have outperformed net of fees. Figure 4 shows a similar pattern for active emerging markets equities, with active performance improving steadily since 2008.

There is also good evidence that managers who perform well over the longer term experience significant periods of underperformance in the short term. The Vanguard Group published a study in 2015 which showed that, of the 552 active US equity funds which had beaten the index over the previous 15 years, 98% had underperformed in four or more individual years.
This is an important consideration for investors who use active managers: they are more likely to achieve good outcomes if they do not abandon a strategy after a short period of underperformance.
Another important consideration for the investor is the fees they are charged. We measured active performance against indices net of fees, which, as discussed, penalises performance as the index bears no costs. Assuming a 0.30% average annual passive fee for UK equities over a 26-year period, the passive fund would have trailed the benchmark by 8%. So while many active funds may have underperformed the index, 100% of passive funds have underperformed.
The point about measuring the real cost of passive management is most visible in emerging markets, where the costs of acquiring market exposure have been higher (until recently typically 0.75%) than in developed markets. Of course, the cost of passive has fallen significantly in the last few years, raising the standard against which active managers will be measured in future, but in many markets passive costs are still material.
Getting the measure of the data
As suggested earlier, outcomes depend on the market and asset class chosen, which generally involves an active decision. For many investors, another decision that naturally flows from this choice is which benchmark to use. In some asset classes, like the S&P500 for large cap US equities, there is broad agreement. Elsewhere, however, there is plenty of room for choice, which can have a big effect on the outcome. For example, two widely-used indices for small cap investing in the US are the S&P SmallCap 600 and the Russell 2000, but the difference in returns between them has been 2.8% per annum over the last ten years. The size of this gap means this is an important active decision for the supposedly passive investor. The choice is not made easier by the fact that, according to Bloomberg News, there are now more benchmark indices in the US than listed securities.
But outcomes also depend on how they are measured. Much of the data used to compare active and passive outcomes is sourced from SPIVA, part of S&P Dow Jones Indices. A recent SPIVA report stated that over 88% of large cap equity funds in the US underperformed the S&P500 Index in the latest five-year period. This conclusion on the US is reinforced from other sources, but there are weaknesses in the SPIVA methodology (see box: Scoring the referee) which call into question the assumption that poor outcomes for active investors are inevitable.
There is also a tendency to extrapolate from the US market to the conclusion that other equity markets are hard to beat. In truth the US is different -apart from anything else, domestic institutional ownership is much higher than elsewhere.
The table in Figure 5 shows five-year performance for a range of asset classes outside the US, using both SPIVA data and alternative measures of active performance.
It covers the number of active funds in our sample at the start of the period (March 2012), those still in existence five years later, those that that were liquidated (including the number that underperformed prior to closure), those launched during this period, plus the number of those that underperformed. This analysis provides evidence that the SPIVA data overstates the number of active funds that underperform net of fees. In six sectors out of seven the adjustments we have made lead to the conclusion that fewer active funds underperform.
Scoring the referee
SPIVA is widely used as a scorecard of active and passive performance, largely because it deals with survivorship bias. It does so, however, by assuming that any fund which has closed or been merged into another fund has underperformed its benchmark. This assumption is not universally valid. We tested UK equity funds that had closed in the past ten years and found that 20% had outperformed before closure. In addition, SPIVA assigns a benchmark to each fund from the S&P Index series irrespective of the actual benchmark used. By contrast, we use stated benchmarks in calculating excess returns. Finally SPIVA does not measure the performance of funds launched since the start of the measurement period. Making these adjustments means that the percentage of funds that underperformed is almost invariably less than the figure published by SPIVA.
Active wins in fixed income
Bond indices have weaker theoretical foundations than equity indices. There is little logic in investing in an index which gives higher weight to the borrowers which have issued more debt, such as the Italian government in developed markets or the Venezuelan government in an emerging markets context. On top of this, the level of turnover (and therefore costs) in bond indices is much higher because new securities – which make up 20% of bond market capitalisation in any given year -have to be included in the index.
A clear illustration of these points comes from high yield and emerging markets debt sectors. In high yield, the largest ETF, the SPDR Bloomberg Barclays High Yield Bond ETF (“JNK”) has tracked its benchmark index (the Bloomberg Barclays High Yield Very Liquid Index) poorly (Figure 6, blue bars). There is a similar picture in emerging markets debt, where the largest ETF tracking the US dollar index (“EMB” or iShares JP Morgan USD Emerging Markets Bond ETF) has underperformed by 0.8% annualized in five years (Figure 6, purple bars).
Even in investment grade corporate bonds, the annual shortfall in ETF returns against the index is 0.4%. This bears out the point that bond markets do not lend themselves to index investing and an active manager does not need to beat the index to do a better job than passive.

It is true that, as Figure 5 shows, the average active manager in high yield and emerging markets debt has not done well against indices either. However, given that it is passive funds and not indices that are investible, the scale of ETFs’ shortfall in fixed income is a better measure of the real benchmark.
The social purpose of active management
Finally, it is worth considering the role active investors play in the broader economy and society. Without active managers, prices in capital markets would be set purely on the relative capitalisation of companies, meaning there would be no mechanism to enhance efficiency or maximise returns for the benefit of the economy as a whole. There is already evidence that recent large flows into passive funds are leading to distortions in markets.
Moreover, we would contend that the stewardship activities of active investors raise returns in the capital markets by encouraging higher standards of corporate governance and directing capital into faster growing industries. This is a role governments in both Europe and Asia are encouraging: in Japan, in particular, policymakers are keen to see stewardship lead to better capital allocation, and everywhere managers are expected to exercise their voting rights responsibly. Many investors are implementing environmental, social and governance (ESG) principles. To do so passively relies on good quality ESG ratings, yet there is little evidence of their ability to provide early warning of problems. We would contend that a competent active manager is better placed to anticipate and avoid ESG issues.
Conclusion
Much of the data used to make the case for passive management overstates the argument: closer analysis suggests many investors in active equity strategies have beaten passive funds after fees. It is true that the characteristics of the US equity market make this the hardest market to beat, but we believe it is incorrect to extrapolate from the US to other equity markets, where there is no evidence that active performance is on a secular downtrend. In bond markets capitalisation-weighted indices are both illogical ways to invest, and hard to track. And for investors who need to achieve a particular outcome, passive may be an impractical solution as they will need to allocate to the right assets and therefore need the skill of an active manager. Factor-based strategies provide useful additional tools, and could be an attractive complement to capitalisation-weighted passive approaches. Active managers also play an important and increasingly recognised role in the wider economy as stewards of the businesses they own and rational allocators of capital. The best approach for investors and asset owners should be to use active, factor investing and passive management alongside each other, choosing active in markets where it is likely to add value or where they have the resources to identify active skill. However, investors need to recognise that active performance is cyclical: selling out of a strategy with a strong philosophy and process after a short period of underperformance risks locking in that underperformance. But the potential value added from active management remains a critical tool in maximising return from a broad portfolio, and we believe that active management will in time start to regain share from passive.
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