Passive always beats active, right? There aren’t any good actively managed funds to invest in — that’s what everyone says.
Take a look at this report showing that nine of the top 10 performing funds this year through June 30, 2019, were actively managed. In fact, according to Morningstar, 49% of large-cap active managers beat the S&P 500 through June.
Why is this happening? Read on to find out.
Asset classes are now less positively correlated
Correlation is how an investment moves relative to other investments. Positive correlation means that an investment moves in the same direction as another investment, while negative correlation implies an opposite movement.
If diversification is to be effective, all investments cannot be positively correlated.
During the market crash of 2008-09, nearly all investments became highly positively correlated as market participants adopted a risk on/risk off trading strategy.
This strategy, selling everything when things looked bad and buying back everything when things seemed better, was the result of the fear that gripped market participants at that time. First, the fear of losing everything, then, the fear of missing out on the snap back.
Investments stayed highly positively correlated for a long time after the crash. Correlations have fallen recently as markets have reverted back to a more normal state.
Why does less overall positive correlation matter? Because…
The beneficiary of lower correlation is superior securities selection
If a lousy investment rises and falls the same relative percentage as a high-quality investment, securities selection has no value. The market is not valuing the better option appropriately.
Risk on/risk off trading strategies place no value on securities selection. If all large-cap stocks rise and fall the same relative percentage as the market moves up and down, you might as well own an index fund because no one will beat market averages.
However, as positive correlations fall, superior securities selection will be rewarded. Markets will value higher quality securities appropriately and actively managed funds will outperform their benchmarks, comparable index funds and exchange-traded funds (ETFs).
Some asset classes will experience better outperformance by active managers since…
Market inefficiencies still exist
Note that only three of the 10 funds that were top performers through June were large cap funds. It is difficult for active managers to beat their indexes in asset classes that are highly researched and followed. It is hard for anyone to discover a fact about Apple that a lot of other people aren’t already aware of and that isn’t already reflected in the price of Apple’s stock.
However, there still are many asset classes where inefficiencies abound. Investment management firms that have research expertise and managerial talent in these areas can — and do — significantly outperform their indexes over a full market cycle.
As a result, six of 10 of the top-performing funds were either small- or mid-cap funds.
Here’s an example of long-term actively managed outperformance
I believe there are attractive actively managed options in nearly all asset classes. Following is an example in the mid-cap asset class.
The T. Rowe Price New Horizons Fund (PRNHX), which went through a management change on March 31, 2019, comfortably beats its benchmark on a 10-year basis (20.79% versus 16.02% through June 30, 2019). That is very significant outperformance. It’s one of the best mid-cap growth funds for that period — out of more than 500 funds. It is a five-star Morningstar-rated fund.
The best passive mid-cap comparator fund is probably the Vanguard Mid-Cap Index Fund (VIMAX), which has a 10-year performance of 15.21% versus its benchmark of 15.15% through June 30, 2019.
I can’t see why investors would throw up their hands and say, “There is just nothing better in the mid-cap space than an index fund.” More than 5½% outperformance over 10 years is an incredibly large performance differential.
Not every active manager in the mid-cap space needs to beat its benchmark to convince me I have adequate choice with actively managed mid-cap funds.
An all-index approach generally isn’t good
Advisor fees are generally around 1% for balances less than $1 million. Subtracting a 1% fee from an index fund’s returns leaves an investor trailing the market by 1%.
In addition, index funds capture 100% of every market downturn. Active managers can sell out of investments before experiencing an entire market fall.
The winning formula uses a mix
Without question, the best way to build a great investment strategy is to use index options for those few asset classes that are widely covered and researched and actively managed choices for all other asset classes where inefficiencies still exist.
It is clear that passive funds generally outperform actively managed funds in the large-cap asset classes, but in nearly every other investment category, active management appears to be the better choice.
This is not investment advice
None of the investment options or approaches discussed in this post should be considered investment recommendations.
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Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
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