MARKET COMMENTARY

Seven Reasons to Question the Popular Assumptions of the Passive Crowd

08.07.2017

Time softens the memory, but it’s important to recall that 2008 brought an economic crisis and led us to the brink of a global financial meltdown. Dramatic measures were taken to stave off the worst, but ushered in an era of unprecedented monetary policy from which we are still recovering. In the US, after years of quantitative easing and a zero interest rate policy, we have finally entered what appears to be a period of normalizing interest rates and traditional monetary policy.

This unusual period fostered a number of market distortions that favored a rising tide approach to investing that lifted all boats, a trend that favored passive investments. Yet just as the tides are cyclical, the popularity of passive investing may recede as markets are influenced by a new set of factors.

Seven illustrations follow that may give investors good reason to question the popular assumptions of the passive crowd.

1. A CROWDED TRADE

Avoid the popular. When any method for selecting stocks becomes popular, then switch to unpopular methods. The wisdom behind these words has been validated numerous times over the years in small and big ways. Japan in the ’80s, the momentum tech/dot.com arena in the late ’90s, financials in the mid‐’00s. While an investment approach may not seem like a sector trade, consider the trend of passive flows and how they may be impacted in a market like that in 2008. More than $80 billion flowed into S&P 500 Index funds and ETFs in 2016, after an eighth straight year of positive returns. It’s a herd mentality, just as with any other “sector” bubble.

Flows by Year into Active vs. Passive Funds

2009 through 2016 ($ Billions)

Source: Investment Company Institute.

2. RISING DISPERSION

The unprecedented multiple rounds of quantitative easing (QE) created an environment that favored investments without discrimination. Easy money eliminated the need to distinguish strong enterprises from weak as low borrowing costs could mask inefficient operations. The historical difference between the best and the worst sectors in the S&P 500 Index illustrates a depressed separation during periods of QE and a more recent rising separation of returns that will allow active managers opportunity to distinguish their performance.

S&P 500 Best-Worst Sector Spread

March 2001 through June 2017


Source: Bloomberg, 6/30/17. Important data provider notices and terms available at www.franklintempletondatasources.com.

3. FALLING CORRELATIONS

As much as the low dispersion environment challenged active managers’ ability to separate themselves from the crowd, high correlations among stocks have limited the ability to separate from the index environment. The chart below illustrates what appears to be a return to a lower, more normalized correlation environment.

Correlation of S&P 500 Stocks

January 22, 1973 through June 30, 2017

Copyright 2017 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

4. BOND INDEXES: RISING DURATIONS AS RATES FELL

The same factors that favored bond index returns for years as interest rates fell, could be a headwind if rates continue to rise. In the fourth quarter of 2016 alone, as the 10‐year Treasury rate rose by 86 basis points, the Citi World Government Bond Index (WGBI) declined by more than 8% and Bloomberg Barclays US Aggregate Index declined by almost 3%. While interest rates were falling, both indexes, as a function of their inflexible structures, were experiencing lengthening average durations and exposure to the risk of rising interest rates. At the same time, many prudent active managers were decreasing their exposure to the potential price declines associated with rising rates.

Rising Index Durations

January 2008 through June 2017


Sources: Citigroup, Bloomberg LP, US Federal Reserve, 6/30/17.

5. NEGATIVE YIELDS = PAYING INVESTORS TO BORROW

Bond markets have many different buyers, many of whom buy for reasons beyond income and diversification. As a result, bond indexes can be shaped by disparate forces,some of which seem to defy logic. For example, indexes shaped by global issuance may hold negative yielding bonds. As of June 30, 2017, more than 15% of the Bloomberg Barclays Global Aggregate Index comprised bonds with negative yields. Moreover, these bonds are issued by some of the most indebted nations in the world.

Principal Value of Negative-Yielding Debt Globally

As of June 30, 2017

Source: Bloomberg, 6/30/17. Includes market value of all bonds in the Bloomberg Barclays Global Aggregate Index.

6. INDEXES HAVE OFTEN FAILED TO MEASURE UP TO ACTIVE BOND FUND PERFORMANCE

Many indexes have looked fairly average when measured against the active funds that use them as their benchmark. This is especially true in the bond arena, which historically has been a less efficient market.

The table below illustrates how several major bond indexes’ performance would have ranked against the Morningstar categories in which they would be compared. Once expenses are factored in, the rankings of index funds and ETFs based on these benchmarks could be even worse. 

Morningstar, Inc. 6/30/17. Past performance does not guarantee future results. See www.franklintempletondatasources.com for additional data provider information.

7. ACTIVE OUTPERFORMANCE HAS BEEN CYCLICAL

Historically, actively managed US equity funds have had long stretches of outperformance and underperformance relative to the S&P 500.

Percentage of Fund Assets Outperformance of S&P 500 on a Rolling Five-Year Basis

January 31, 1970 through December 31, 2016

Source: Nomura Instinet: Joseph Mezrich. Shows the percentage of US actively managed equity mutual fund assets that outperformed the total return of S&P 500 Index based on trailing five-year performance after fees. Funds are those in existence for five years or more and belong to US growth, growth and income, and income funds (based on CRSP fund objective code). Percentage of fund assets outperformance is calculated as the ratio of total net assets of actively managed equity funds that outperformed S&P 500 over total net assets of all the actively managed equity funds. Period of analysis is from January 1970 through December 2016. Past performance does not guarantee future results.



This communication is intended solely to provide general information. The information and opinions stated are as of August 8, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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