Active investment management may be poised for a resurgence, potentially reclaiming a significant share of global funds under management. While sceptics might find this prospect as unlikely as the legendary Ryder Cup comeback at Medinah, we may be near a turning point.
Bad Reputation
Active management has had a bad press for many years. Most managers underperform their benchmark in most years, the fees are too high, transparency is too low, and the effort required to select and monitor a successful manager is not justified by results.
This narrative has been the dominant one for many years now. Index-tracking funds, known as passive investing, now account for between 45% and 50% of US equity assets under management, up from about 25% just a decade ago.
Reflecting this trend, the number of Mutual Funds and Exchange Traded Funds (ETFs) is about three times the number of individual stocks (US data). In the late 1990s it was about one for one. Of course, not all these funds are straightforward index trackers, but it demonstrates how far the industry has moved away from the old-fashioned method of selecting individual stocks for a portfolio.
How Passive Investing Influences the Market
Most assets in passive funds are managed on a systematic basis with no regard to fundamentals such as earnings and their relation to the stock price. While passive funds come in many types, a common theme warrants caution. For reference the total market (all data is for the US) is about $45 trillion.
Index tracker ETFs, buying stocks based on their index weight, were about $9 trillion in the US in 2023. As funds flowed from active management to passive this meant buying more heavily weighted stocks, potentially driving up their prices. Expectations of continued flows, consistent with the shift from active to passive, have allowed these premium valuations to be sustained and possibly expand further.
An obvious consequence of this systematic buying behaviour would be for other investors to try and front-run the index trackers by buying stocks with positive momentum. Although momentum is not the most popular of the smart-beta products ($2 trillion), there is still over $100bn in ETFs specifically following this factor. Many quantitative strategies, possibly $1 trillion, including some ETFs and money managed by hedge funds, also incorporate a strong momentum component in their stock selection.
Passive investing, sold for its cost-effectiveness and performance, has gained many followers. However, this growing popularity may be creating an investment bubble. Passive investing was supposed to reduce emotional trading, such as panic selling during downturns or chasing hot stocks. Yet, passive strategies are clearly chasing hot stocks, raising concerns about whether investors will maintain their positions during a market downturn. Passive investing, especially in the form of momentum, is now a high-risk strategy.
Momentum: The New Focus of Active Managers
What is most interesting about the momentum factor is not found in passive funds – it is in the active sector. The S&P Dow Jones SPIVA report, produced annually since 2001, is a scorecard on the performance of active managers. In a typical year 64% of active managers underperform their benchmark and only in occasional years does the average manager beat the benchmark.
Data is scarce for prior decades but many research papers conclude that value investing was the dominant strategy among active managers. Names like Ben Graham, Warren Buffett, Tony Dye and Neil Woodford are synonymous with that era.
Value investing was successful for decades but was a casualty of the dot-com boom (peaking in 2000) when growth (mainly perceived growth) became the dominant theme.
Using data from the SPIVA report, and some factor ETF returns since 2001, we observe a significant shift among active managers. Momentum, which was insignificant as a driver of returns before the Global Financial Crisis (GFC) in 2008, has become the dominant factor in the last 10 years. Active managers performed better when momentum was working. Consistent with this, active managers as a group tend to underperform when value investing is successful (indicating a tilt away from value) and when smaller stocks outperform (as they are chasing larger stocks).
This represents a substantial shift in style compared to pre-2000.
Central Banks and the Rise of Momentum
A feature of the financial system this century has been the control that central banks have tried to exert over economies, often through interventions in financial markets. Any sign of trouble and rates were cut to zero, they restarted Quantitative Easing (QE), and introduced new measures to add liquidity to struggling markets. Economic agents respond to these incentives, and the massive growth in debt financing is partly due to the increased likelihood of bailouts - either directly, like the banks in 2008, or indirectly through super-low interest rates, QE, and extend-and-pretend policies from lenders. This era of zombie companies and the “Fed put option” probably began with Alan Greenspan’s ill-judged response to LTCM in 1998. However it accelerated after the GFC, significantly affecting market behaviour.
From the 1940s to the end of the century “buying the dip” was generally absent - one-day returns after down-days were negative on average. In the last 20 years they have, on average, been positive.
Additionally, examining a wide range of equity indices, we see that volatility in uptrends has tended to decrease over the last 30 years, while volatility in downtrends is broadly the same. Bull markets, therefore, have recently given investors greater confidence that taking more risk will be rewarded, supported by the narrative that central banks have your back.
Why this has led to momentum becoming a dominant strategy is not entirely clear. It could be that themes can run longer in an era of central bank protection, consistent with the golden years of momentum performance in the 2010s. There is likely to be a behavioural angle, as investors tend to exhibit a herding mentality toward successful strategies. Furthermore, the growth of Artificial Intelligence (AI), which has learned from markets where momentum worked, has likely incorporated this driver into their models as well.
Navigating the Risks of Momentum Strategies
In recent years, momentum has not performed as well. While it outperformed the market in the 2010s, its gains in the 2020s have been modest compared to the broader market. These recent absolute gains have likely maintained investor confidence in the strategy.
The sharp fall in momentum tracking at the end of 2021 may have faded from most memories but it was a reminder of how small the exit door can be when everyone tries to leave a crowded building at once. Volatility in momentum-tracking ETFs spiked to about twice the normal level but remained well below what you would expect in market-wide volatility events. A real test may still be ahead.
We cannot be certain how the central bank will respond. There is no indication that they regret their post-GFC actions (unfortunately), and so might well repeat the prescription. However, central banks are far from the only factor influencing market performance – that is just a myth promoted by financial journalists.
To alleviate these risks then diversification is crucial. Consider how much of your portfolio is driven by momentum, whether intentionally or not. Active management often performs better in a downturn, and one is certainly overdue, but it would still seem prudent to check how much your own active manager aligns with momentum strategies.
To conclude, there is an opportunity for active managers to take back some market share but, as a group, it is unlikely that they are positioned to do so.
September 2024