Active Funds Can Still Carry Their Weight
Active management has been increasingly neglected by investors for the last decade. It's about time they get another look.
Happy Thursday. Welcome to our second edition of Business As Usual, a digest for ‘deep thinks’ at the intersection of finance, culture, politics, and the things that fall in between.
Over the last two decades, a pivotal shift has taken place in asset management. I’m talking about the drastic transition away from actively-managed funds and into passively-managed funds. In 1995, passive equity and bond funds made up less than five percent of all assets under management (AUM) in markets. This year, passive funds represented 48% of AUM in equity funds and 30% of AUM in bond funds.
In the first edition of Business As Usual, we glazed over how passively-managed funds have soaked up the lion’s share of money in markets. We also touched on how passive funds—mostly index funds—were basking in the glow of Big Tech. Active funds, which traditionally cost more, have been beat by their cheaper alternatives because of the outsized influence that a handful of successful Big Tech companies have had in the market. The last decade has been an unraveling of the ‘era of the old-fashioned stock picker’, one which has accelerated as the volume of assets wrapped up in passive funds surpassed active funds in September of last year. In short: investors were tired of paying more for less. However, that unraveling might have been overly dramatic.
The truth is that passive U.S. equity funds have managed to return at a rate of ~9-10% per year, even in a time where United States’ real GDP is estimated to fall by over 6%. Pretty impressive. However, part of the reason for the growth is the country’s central bank policy. As the pandemic rippled outward, the Federal Reserve bought up billions in government securities with newly minted money. The Fed and Congress provided stimulus — not just for the average American, but for the banks & day-traders. However, all that stimulus had—and will have—a greater consequence.
The immediate consequence was the rush back to equities. When the Fed propped up the market, investors bought up positions they dumped back in March. This essentially squeezed all of the near-term growth out of stocks, and many stocks in indices like the S&P 500 or NASDAQ are now trading at a considerable premium. This means that one of two things will have to happen. Either: 1) stock valuations will have to come back to baseline (as the economy recovers post-COVID) or 2) investors will continue to buy stocks at a premium because There Is No Alternative.
The long-term consequence is still panning out — but it’s likely that the United States (and other developed economies) will see greater inflation and reduced growth in a post-pandemic world. Fed Chairman Jerome Powell already indicated that the Fed will allow inflation to rise above its 2% target for the foreseeable future. This has some investors worried about the possibility of inflation rates rising as high as 4%. Morgan Stanley’s chief of U.S. equity strategy, Mike Wilson, says long-term inflation and interest rates might rise because of the stimulus & associated government spending. Billionaire investor Stanley Druckenmiller says he feels confident that inflation will “top 4%, gold prices and bond yields will be higher, and the unemployment rate will be around 7%.” That’s all hearsay at this point, but given that forecasts of equity returns are looking down and forecasts of inflation are looking up, investors are feeling weary about less robust returns from traditional vehicles.
You can’t beat inflation by just saving money in your bank account anymore — this isn’t 1980. People who want to see their money appreciate will be forced to take on systemic risk by investing in stocks. This has come to be known as ‘the TINA market’. While indexing and passive funds will likely be able to help the every-man beat the quarrelsome prospect of rising inflation, an average portfolio will net average returns. Those seeking above-average returns are going to have to look to stock-picking and active management for a chance to rise above traditional alternatives.
This might be one reason why individual investors and firms are singing a slightly different, less dismissive tune about stock-picking and active funds. GGV Capital’s Jeff Richard observed in an interview that “index funds are fine but … we’ve been moving into an era where picking and selection can drive big returns.” The reality is that they can also drive big losses if you’re wrong. However, perhaps the biggest motivation for the change in tune is the recognition that three of the best-performing ETFs of 2020 are actively-traded. It just so happens that they all come from one fund manager in particular: ARK Funds.
ARK’s five active ETFs are “thematic” — focusing on specific trends or industries such as technology & robotics, genomics, fintech, and internet companies. Almost all five of the funds have doubled this year. Thematic funds have transformed from niche to trend in the marketplace this year, fueled in-part by the retail trading crowd. There are other active managers in the thematic marketplace benefiting from the retail rush. Among them are companies like Roundhill Investments and Global X. Roundhill manages two funds for esports & sports betting which have soared this year. Global X manages over a dozen ETFs, many active, which have vastly outperformed the S&P 500. Established players like Vanguard (which runs its flagship Contrafund) haven’t seen the same inflows as these smaller players, but they too have beat the benchmark — and they’re not exactly new to doing so either.
The point I’m trying to make here is that investors have systematically abandoned active management for indexing over the last decade. Yes, it can be considerably cheaper than active alternatives. However, it’s only one way of gaining exposure to the market. In order to be successful, you need to have a lot of different overlapping and separate exposures. Indexing isn’t positioning itself well for a post-COVID world that might look vastly different. It sure as hell isn’t going to help you maintain these lofty returns we’ve seen over the last decade, even if it might help you avoid some of that potential encroachment from higher inflation and lower overall returns.
Positioning is critical. Now isn’t the time to look at what worked and made money last year or five years ago. It’s time to send money to work in terms of the future that you foresee. Indexed products like $SPY and $QQQ might be a part of that vision (after all, many of those large-caps aren’t going anywhere yet). However, that growth-value mix alone will not provide you the outsized alpha you’re seeking. Indices aren’t necessarily capturing all the momentum stocks on markets, and they’re not even necessarily supposed to. They’re supposed to be consistent — but I said it once and I’ll again: an average portfolio will create average returns.
In my view, active funds & stock picking represent a market opportunity to beat the benchmark — at least for the next 5 to 10 years. For that reason, I think it’s something you should weigh in to your current portfolio. It’s time to position your portfolio to create the kind of returns that make you feel above-average and special. More importantly, it’s time to prognosticate: to build a lean portfolio inclusive of passive and active funds, individual stocks you believe in, and opportunities with considerable upside. If you don’t, it’s likely you’ll be left out in the cold when the future comes knocking.