Active Versus Passive: How Did We Get Here Anyway?

When talking with clients these days, passive versus active management is the red-hot topic. Many point to underperformance by active managers in the past few years as proof that the days of the stock picker are numbered. What strikes me during these conversations is that so many investors take it as a foregone conclusion that index funds will continue to outperform regardless of the backdrop. But is that true? Based on this chart, the case could be made that the fate of passive investing’s performance is tied to how the Federal Reserve Board acts going forward.

Swamped by Easy Money
Heartland Advisors Value Investing Active Management Chart
Source: Evercore ISI and Standard & Poor's, 2003 to 2016
Difference from Passive S&P 500 Performance: Evercore ISI looked at a universe of 750-plus active managers with long-term open-end mutual funds, excluding affiliated fund of funds, and measured the median annual cumulative total return of that group. This performance was then measured against the annual change in the S&P 500 to evaluate whether there were excess returns generated for the period.
Past performance does not guarantee future results.
 
As shown, the average active manager was handily beating the S&P 500 Index prior to the Fed unleashing the power of Quantitative Easing. As the central bank’s balance sheet ballooned, so too did returns of the broad Index against fundamental portfolio managers. 
 
Intuitively, it makes sense. Excessive liquidity and low interest rates can paper over a lot of flaws at the company level. With businesses receiving little or no penalty for poor capital management or unhealthy debt, investors have been free to outsource investment decisions to index providers and turn their attention elsewhere.
 
Now that rates are rising and the Fed has signaled a commitment to shrinking its balance sheet—and, consequently, reducing the liquidity sloshing around the financial system—we think it is prudent for investors to reconsider their assumptions. As the old adage goes, past performance does not guarantee future results.

 

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Author

Heartland Advisors Value Investing Relationship Manager Michael Kops

Michael Kops

Kops is Vice President of Sales. He has 13 years of industry experience, 7 at Heartland.

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