Active management isn’t dead

The 2010’s was a long decade for active managers. The narrative of index-tracking being better than active really took hold – and in every year, the data seemed to stack up. According to S&P Dow Jones, the majority¹ of large cap US fund managers underperformed vs the index in every single year between 2010 and 2019!

All the way through, managers were pleading their case, with each new year greeted by the proclamation that now would be the time for active management to deliver that long-promised performance. And it just didn’t happen.

Here we are again, in 2021 and the same cries are ringing round once more. So, why should we believe them this time? What’s changed? We offer both active and passive solutions at 7IM, so we’re in a good place to give our unbiased opinion – we don’t have a dog in the fight (or rather, we’ve got both dogs in the fight, so we are most interested in a peaceful resolution).

Passive investments do have a lot of strengths. They’re cheaper, they can give more exposure to a wide range of asset classes, and highly liquid options are always available. Add performance into the mix, and it sounds like a match made in heaven.

Passive index investors buy the index, not the individual businesses – which can feel a bit like a perpetual motion machine. Investors buy an index which allocates the most money to the most popular stocks, increasing their price and making them more popular. And all of this ignores the company fundamentals! At no point is a passive investor choosing whether one company is better than another – they let the index do that for them. It’s certainly less work.

But active managers also have some good points. Choosing between good and bad companies makes sense – and picking up on a trend before it gets going can deliver outstanding returns to investors. It just hasn’t been happening recently.

As an active manager you need two things to happen. First, you need to buy companies that the market is undervaluing, and secondly, sell the ones the market is overvaluing. That’s the bit you have control over. The part you can’t control is whether the wider world comes round to your point of view – because that’s what makes the money! You need to be right slightly before others. If you’re right in theory, but wrong on timing, you can be left holding a stock that no one’s buying. Which means you’ll lag the index, which follows the popular companies.

In recent years, the wave of passive indexing has swamped stock pickers. It’s been difficult to get to know what a company is worth, when its stock price is being driven by passive index flows from monthly savings accounts, rather than fundamental analysis. But we think a change in sentiment is upon us, and investors are starting to care about companies again.

The recent rise of thematic investing is proof that a lot of people are starting to care about companies again. When making a thematic investment, you will likely have some sort of view on the companies involved. And thematic indices are different from conventional indices – they are often more like actively managed funds than passive investments.

Take, for example, electric vehicle ETFs. You would only choose to invest in such a product if you think electric cars will do well. You therefore have some conviction that the companies in the ETF will do better than the average company by virtue of being involved in the production of electric cars.

As investors are starting to care about companies, the good active managers will start to see some of their choices validated. And as that happens, investors will begin to realise that index investing isn’t always the best answer. As more money flows to active managers, there will be more capital discriminating among businesses, so good companies will be rewarded, and bad ones punished (in share price terms).

Of course, finding a good active manager is the difficult part for investors. You need a solid process, and a lot of patience. Fortunately at 7IM we’ve been building a selection process for the last decades, and we give it the time to work.

¹https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2019.pdf