• Wealth Management

Active Management Re-emerges as Economic Trends Shift

The last seven years have been an uphill battle for active managers, but a changing macro-economic backdrop suggests that active management could soon see a lift.

In the wake the financial crisis, a flood of investors began pouring from active management—a portfolio management strategy where a manager relies on research and forecasts to look for specific investment opportunities—to passively managed index funds and exchange-traded products. For some, this outsized movement from active to passive has presented the question “Is active management dead?”

While it's true that active managers have had a tough go over the last several years, changing economic winds now suggest that investors should hold off on any epitaph for active management.

“Over the last seven years, passive management has benefited from huge tailwinds—low volatility, high correlations, slow growth and reduced fiscal spending—all of which have worked against active management," says Lisa Shalett, Head of Investment and Portfolio strategies at Morgan Stanley Wealth Management and a member of the firm's Global Investment Committee. “As those things fade, we think it would be foolhardy to abandon active management."

This isn't to say that investors should abandon low-cost indexing either. There are times when it pays to tilt one's assets toward passive strategies, and times when it makes sense to be a little more active. But while the current environment still favors a predominantly passive approach, active managers may soon have an edge.

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Tough Environment for Stock Pickers

It's easy to see why many investors have given up on active management.

Between 2010 and 2016, just 33% of U.S. large growth stock pickers beat the Russell 1000 Growth Index, according to Morgan Stanley's analysis of Morningstar data. Fixed-income managers have also struggled to stay ahead. Slightly less than half of U.S. intermediate-term bond fund managers bested the Barclays U.S. Aggregate Bond Index over that period.1

Fund flows have reflected this dwindling confidence in active management. Since October 2007, investors have pulled $875 billion from active funds and shifted $932 billion into index funds and exchange-traded products. Though assets in active strategies still outweigh that of passive, exchange-traded products are on track to hit $6 trillion in assets in 2019, up from $3.5 trillion in 2016.

 

Growth in Passive Management Has Surged Since 1999
Global ETF/ETP Assets Under Management ($ Trillions) as of 7/12/16

Source: Morgan Stanley & Co., Morgan Stanley Wealth Management GIC. See footnote 2.

Macro Changes Turn the Table

Before investors count out active management, however, it's important to understand that a combination of macro-economic trends has worked against active management over the last seven years, while benefiting passive styles. Morgan Stanley's Global Investment Committee believes that several of these trends are set to reverse, potentially giving active managers an edge.

“We are in the early stages of a major regime shift, from monetary to fiscal policy; deflation to inflation; and low volatility to high volatility," says Shalett. “History suggests that this is when active managers have the best potential to find mispriced securities and earn their keep."

Similarly, low GDP growth has constrained company profits, making it difficult for stellar performers to stand out. Against a changing backdrop, active managers may be able to add alpha in rising markets while dampening volatility in down markets. Over the last 20 years, in fact, top-quartile managers have significantly outperformed their benchmarks in down years.

 

Passive Benchmarks Tend to Overweight Risky Exposures, Making It Easier for Active Managers to Outperform in Down Markets

Manager Style & Rank Among Peers Down Years Up Years All Years
Large Core Top 25% Median 6.0 1.0 2.4
0.9 -0.7 -0.6
Mid Core Top 25% Median 8.1 3.1 5.3
1.3 -0.6 -0.5
Small Core Top 25% Median 10.7 3.9 6.9
3.1 0.1 0.7
Source: Morgan Stanley & Co., Morgan Stanley Wealth Management GIC, Morningstar. See footnote 3.

Further, long periods of active manager underperformance have occurred before, most recently from 1983-1988 and 1995-2000. Each time, active management (after being pronounced dead) proceeded to surge thereafter, delivering superior results as you can see in the chart below.

 

Periods of Risk-Adjusted Returns of Passive Benchmarks Are Not Unprecedented

Source: Morgan Stanley Wealth Management GIC, Bloomberg, Factset. See footnote 4.

Taking a More Tactical Approach

To be sure, there are times when passive prevails, and times when active managers truly can add value.

To understand the correlation between these styles and the broader economy, Morgan Stanley has identified eight factors that are indicative of a favorable environment for active management. These range from yield slope trends and value dispersion to market breadth. Using these factors, investment professionals can gain insight into how to tactically allocate assets across passive and active strategies, for different asset classes.

As the chart below shows, over the last two decades, a dynamic allocation between active and passive strategies significantly outperformed a static allocation to passive, active or an equal mix of both.

 

Dynamically Allocating Between Active and Passive Using Our Model Has Outperformed Static Strategies

Source: Morgan Stanley Wealth Management GIC, Morningstar

Based on this data-driven approach, investors in some asset classes would benefit from shifting to a more active approach. In the case of small growth stocks, for example, historical patterns suggest that investors in this space should opt for a mix that is 70% active and 30% passive. Over a seven-year horizon, the model calls for a large core mix that is 45% active and 55% passive. 

Holding Active Mangers to a Higher Standard

Just as important as finding the right mix of active and passive is identifying talented active managers who don't simply mimic their benchmarks.

With passive strategies offering broad and inexpensive market exposure, investors should focus their active efforts on managers whose portfolios have minimal overlap with their benchmarks—a measure known as active share. “This is a critical part of our due diligence and manager selection," Shalett says, noting that Morgan Stanley has a patented quantitative tool to gauge manager conviction across different market conditions.

“Our analysis shows that talented managers can add idiosyncratic alpha beyond what can be attributed to market appreciation or a defined set of factors," Shalett adds.

What about getting your active exposure via smart beta? The last several years have given rise to rules-based products (a.k.a. smart beta) that combine the systematic approach of passive investing with fundamental screens that weight securities on such factors as valuation, momentum and financial stability, to name a few.

While these low-cost products offer more nuance than traditional market-cap weighted indexes, it's still too early to say whether smart beta is a worthy substitute for human judgment when the macro economy is in flux.

For more details on Morgan Stanley's Active/Passive model, ask your Financial Advisor for the full report, “The Case for Active Management.”  If you aren’t currently a Morgan Stanley client, you can find one in the locator below.

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