Fashions wax and wane in investing as much as in any other field. But one fashion that many commentators believe is much more than a passing fad is passive investing. So much so that some would extrapolate the explosive growth of passive funds in the last few years and predict the demise of active investing all together. But to adapt a quote from Mark Twain: reports of the death of active investing are greatly exaggerated.
Without question, the last few years have been tough for active investors – adapting to a new monetary policy landscape which flooded markets with cheap capital and caused asset prices to surge, largely indiscriminately, proved tough. Excess capital, it seems, is like kryptonite to alpha – the returns of a fund over those of a benchmark index. It removed competition for capital and constrained the ability of active managers to ration investment to more deserving assets. But this may now be changing as interest rates around the world start to stabilise and grind slowly upwards.
Another important consideration is that, for much of the last seven years, the daily and even weekly returns of stocks and bonds were negatively correlated. Good days for stocks were bad days for bonds, and vice versa. Longer-term annual returns for the two assets, however, were largely positively correlated – total annual returns for US stocks and bonds were positive for both assets in six of the last seven years. This situation allowed investors to hold a passive allocation to stocks and bonds which both dampened day-to-day portfolio volatility and delivered positive annual returns from both assets in the longer run.
We doubt the benign environment of the last few years, which provided a significant tailwind for passive investing at the same time that it frustrated active managers’ quest for alpha, will persist. As central banks gradually drain excess liquidity, and we enter the more familiar latter stages of a business cycle, we expect that the environment for active investing will improve markedly. To be clear, we do not expect a sharp reversal of asset flows to passive funds as the environment shifts, but we do anticipate that the outflows from active funds will level off and begin to reverse.
A key driver of this is the business cycle. There is little question that the current business cycle is elongated. We see a very real prospect that the current expansion could set a new record, ultimately outlasting the 1991-2001 expansion in the US. However, we are clearly morphing from a “lower for longer” bias, which supported all assets and flooded the market with cheap capital, to a “reflationary” bias. In a reflationary environment we would expect rising rates, more competition for capital, and greater differentiation in the performance between firms – all important ingredients in generating alpha.
Read more: What can investors expect from 2017?
In sum, we have a sense of modest optimism that the business cycle still has some way to run, but also with a sense that we are entering a new regime. Simple passive approaches that worked while central banks were dousing the market with capital may prove wanting, and the headwinds for active management might be easing. But investors of all approaches can take some cheer that we appear to be entering a period of slightly above trend growth, which for the first time in five years is coordinated across all major economic blocs.
There remain many unknowns for 2017, not least with regard to trade policy, but with economic growth broadening out and turning up, asset markets can probably deliver positive, if modest, returns this year.