Don't Write Off Active Management

Active managers must overcome their cost disadvantage against index funds but many outperform their passive peers in areas such as emerging markets

John Rekenthaler 12 September, 2018 | 10:39AM

Financial targets

Vanguard’s recent short paper debunked the idea that active management performs better in certain market segments as a myth. But that claim is untrue: over any time period, some categories of active funds fare better than others.

Not only do some categories of active funds outperform others over a single time period but extending those studies also uncovers some persistence. Active emerging markets funds routinely give indexers a stronger fight than do large-blend US stock funds. Small-company stock funds have more relative winners than do blue-chip funds.

But no matter what the investments, or where their location, active managers must overcome their cost disadvantage by outsmarting other market participants. However, today’s participants are better prepared than ever before, which means that active managers can no longer succeed by being very good, or even excellent. To succeed, they must be outstanding.

Indexing is not as prevalent as is commonly believed. In a 2017 report from BlackRock, “Index Investing Supports Vibrant Capital Markets”, the fund manager measured how all investment assets are deployed.

According to Vanguard, since the early 1980s, the percentage of US assets managed professionally has risen to almost 80% from 40%. The pattern is similar outside the United States. One might think that development is linked to the boom in indexing. But that is not so. On the contrary, BlackRock’s paper demonstrates that most of the growth in professionally managed assets is driven by growth in active management.

Active Funds in Control

Within US equities, BlackRock reports that 12.4% of the stock market’s capitalisation is held by index funds and exchange-traded funds. Those figures are from December 2016; they are somewhat higher today. Another 16.8% is possessed by active funds, which means that publicly registered funds hold just over 28% of the US stock market. The remaining 72% operates largely in the dark, as there is only limited information about how those assets are invested. Pretty clearly, though, much if not most of those funds are actively run.

Active management is more prominent yet when viewed from the global perspective. The conclusion is unmistakable. BlackRock finds that fewer than 17.5% of the world’s equities are indexed, either directly through funds or indirectly as part of an institution’s investment strategy. The vast majority are managed actively.

What’s more, those active assets affect the stock market's pricing much more than do the indexed assets. Not only do the indexers take the quotes that the markets give them, rather than sway prices by buying those securities that the active manager finds appealing and selling those that she does not, but they are also much less likely to trade.

Indexing, justifiably, dominates the headlines. For many years now, index funds have dominated the sales charts, with their actively managed rivals in net redemptions a pattern that shows no sign of slowing. But indexing is not yet large enough to distort the financial markets.

 

John Rekenthaler has been researching the fund industry since 1988. He is a columnist for Morningstar.com. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author John Rekenthaler

John Rekenthaler  is vice president of research for Morningstar.