It has been an astonishing decade for passive funds in both equity and bond markets. The recent Active/Passive barometer from Morningstar found that the success rate for active equity managers since 2014 is just 17.6%, and for bond managers just 25.1% over the past 10 years.
The prevailing wisdom is that the era of loose monetary policy flattered passive investments – so should there be a change as the environment shifts?
The strong performance of passive over active funds is usually explained away by focusing on the dominance of a handful of large caps globally, particularly the technology giants. This is certainly part of the story. Analysis from AJ Bell found that only 35% of active equity funds have beaten the average passive fund in their sector over 10 years, but when global and US funds are taken out of the data, that rises to a more respectable 46%.
The magnificent seven accounted for more than 60% of the rise in the S&P 500 in 2023, and the GRANOLAS (GSK, Roche, ASML, Nestle, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, SAP, and Sanofi) in Europe have also led index performance.
It is also worth noting that the outperformance of passive may be both cause and effect. The more that has gone into large cap, the more it has boosted performance.
This large-cap dominance is unusual. George Cooke, manager on the Montanaro European Smaller Companies fund, said: “The outperformance of large caps over small caps has been a major theme over the past decade. Yet the small-cap premium is a well-studied phenomenon. For the last two and a half decades, that’s worked a treat and small-cap companies have done very well. However, the last few years have been the most difficult time for small versus large since the 1990s – a decade horribilis for small caps.”
The picture may be changing. In the US large-cap blend Morningstar Category, 51.7% of active equity funds outperformed their passive competitors in the year to the end of June 2024, up from 41.9% in December 2023.
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Christopher Rossbach, manager of the J Stern & Co World Stars Global Equity fund, said: “The market is moving and broadening from the magnificent seven.” While he still holds four of the seven, he has been selling Nvidia to buy companies such as Diageo, Nestle and LVMH, which have been overlooked.
Laith Khalaf, head of investment analysis at AJ Bell, added: “Some poor performance from the magnificent seven could be a real gamechanger for active funds.”
There are signs of this starting to happen. Tesla’s performance has long since ceased to be magnificent, while the lofty expectations built into Nvidia’s share price appear to be giving investors pause for thought.
Beyond the US
Outside the US, the picture is different again. In Europe, active managers have seen similar problems of large-cap dominance. Unlike in the US, this hasn’t changed yet, with only 20% of active managers beating their passive counterparts in the one-year period to June 2024, down from 23.9% at the close of 2023.
Smaller companies have continued to lag for the year-to-date, with the MSCI Europe ex UK Small Cap index up 8.1%, compared with 15.6% for the MSCI ACWI. This weakness has come in spite of the two interest rate cuts from the ECB, which have historically been a trigger for better performance from small caps.
In the UK, the one-year rate success rate for active managers fell to 41.2% in the year to June from 63.5% in December 2023. But more recently, small caps have started to perform better, which augers well for active managers. The FTSE Small Cap is up 7.7% for the year-to-date, compared with 6.4% for the FTSE 100.
The UK has seen another odd phenomenon. AJ Bell pointed out that retail investors have withdrawn £89bn from active funds since the beginning of 2022, while at the same time investing £37bn in trackers.
The IA statistics show the problem is not the flows into passive funds, which have remained steady over time, but that flows into active funds have collapsed. The aggregate effect is the same, but the implications are slightly different. It suggests that investors are more likely to hold faith with passive funds, but become disillusioned with active funds during periods of market weakness.
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The ‘stickiness’ of passive flows may highlight a problem with the way people use active funds. Simon Evan-Cook, fund manager on the Downing Fox range, said he expects all good active fund managers to go through periods of underperformance, but does not expect all of the underlying funds to experience highs and lows at the same time. For example, a value manager’s trough can be more than compensated for by a growth manager’s purple patch.
The problem is that investors find it uncomfortable to hold through an active manager’s tough patches, and may switch funds at the wrong time. A passive investment does not appear to bring about the same behaviour. This may be self-perpetuating: if investors consistently get a better experience with passive funds – because they tend to buy and hold – they may be more comfortable with them.
There are signs of a shift in the bond market. There are more problems inherent in passive bond exposure, with market weighted indices inevitably giving the greatest exposure to the most indebted areas. However, when bond yields were low and prices high, this wasn’t a problem. However, as bond markets have become more volatile, active investors have made hay. The Morningstar data shows the average one-year success rate for active bond managers across the 20 categories analysed rose to 57.9% in June 2024 from 49.8% in December 2023.
A changing environment?
John Husselbee, head of the multi-asset team at Liontrust, said there are more signs of a changing environment. “The last two times the Vix index went through 60 – as it did in August – we saw real fundamental change.” He gives the example of 2008 and Covid. He also said that the gap between the S&P 500 marke- cap weighted and equally weighted indices is historically wide, with investors having to go back some way in history to see a similar phenomenon.
“The risk today is that for a market-cap weighted portfolio, some of these stocks have deserved their ratings in terms of their earnings, but you are starting to see similar earnings coming through elsewhere. At some point those earnings will start to go beyond what we see in the magnificent seven and the market will start to turn into a whole load of comparison shoppers, saying that they can find the same growth, but cheaper.”
See also: Is there any point investing in the US actively?
That said, while the outlook for active versus passive appears to be changing as the environment becomes more volatile, the flow problem remains one of the biggest challenges for the long-term performance of active over passive. The latest IA data shows Index trackers still dominant in July, with net retail sales of £3.4bn, versus a £2.1bn outflow from actively managed funds.
Active managers across the world are battling this phenomenon. Buy backs and merger and acquisition activity can compensate to some extent, but in general, the more money that goes into passive over active, the more large-cap stocks perform. Passive flows are slowing, but any renewed enthusiasm for active funds may be slow to emerge.
