Recently, there has been substantial focus on how active manager strategies have underperformed passive investing especially in the past few years. For the three years ending January 31, 2017, active management has lost $475 million in outflows while passive managed mutual funds and exchange traded funds strategies have gained $1.3 trillion, according to recent research from MorningStar.[1]  Many investors have given up on beating the markets, so they don’t even try. Instead of trying to beat the markets and underperforming, why not just invest in the markets themselves?

Historically, there are time periods when active managers outperform passive investing and vice versa. Current active manager performance challenges are not unprecedented. Periods of underperformance tend to correspond to unusual market environments, e.g. the Late ‘80s. the Tech Bubble, and the Post Credit Crisis.

The Popularity of Indexing

One reason investors have been happy with index investing is that markets have been going up for almost a decade. Market participants have gladly accepted the returns and risk the market has provided since there has been no significant correction for nine years.

Index investing, in its essence, is “investing for average.” With “average,” investors recently have achieved decent returns at very little cost. “Average” has been successful for several years, and many investors have been lulled into a false sense of security.

Quantitative Easing Distorts Markets

It is not safe to assume that the markets will continue to produce the returns of the past decade over the long run. Since the market crash of 2008, quantitative easing (QE), although necessary, has disrupted capital allocation decisions and has distorted market cycles.

Subjective hopes can deviate from objective reality which is why in today’s market environment stock prices are drifting from the data. Some define the phenomenon as confirmation bias and others call it reflexivity.

Much of the hope that is driving this reflexive environment is based on QE. Investors believe that the current trend of the past nine years will continue its upward trajectory, and if the market corrects, the Fed will institute another round of QE to stabilize markets.

Active Management Versus Indexing

The current market environment favors index investing. Active managers typically underperform in unusual market environments similar to what we have recently experienced. The important thing to remember is that the performance of active managers is cyclical, as is indexing. History clearly demonstrates this. Some periods when active management flourished are in the late 1980s and after the tech bubble burst during 2000-2002.

With indexing, there are also a few other points to consider. The largest and most expensive stocks drive index returns, and capitalization drives returns instead of fundamentals. Benchmarks simply provide market exposure, not protection. They participate 100% in up markets and 100% in down markets as well.

Historical Bear Markets

No one knows how long the current bull market will last. Because of the distortion of the market, it is hard to tell. A bear market, though, is an eventual inevitability. It is critical that investors understand this because we have experienced some pretty vicious bear markets in recent history. These are the S&P 500 peak to trough bear market returns:

• 1973-1974: -48%
• 2000-2002: -49%
• 2007-2009: -54%

While index strategies do well during bull markets, only active strategies are able to outperform the markets over a complete market cycle, peak to peak or trough to trough. Indexes match the markets, both up and down. The only opportunity one has to outperform the markets over long periods of time is through active management. Beacon Pointe does not believe this a secular change.

What Should You Do?

When it comes to index investing, proceed with caution. An old, but reliable, market axiom says that whenever an investment decision becomes obvious and appears to be “easy money,” caution is in order. Just think of the “nifty fifty” singular decision strategy of the early 1970s or those who invested in tech stocks in the late 1990s telling themselves, “It’s different this time.” A good movie to watch is The Big Short, which does an excellent job portraying the house flipping easy money phenomena in the mid-2000s.

About Beacon Pointe Advisors

Beacon Pointe Advisors was founded in 2002 and has over $9 billion in assets under advisement (as of 12/31/16). As a 100% employee-owned, independent investment advisory firm, Beacon Pointe provides clear and objective investment advice, solely advocating for our diverse group of clients including institutions and high-net-worth individuals.

Beacon Pointe utilizes a diligent manager research process. Through our rigorous evaluation process, we find stable and proven but undiscovered managers. Our proprietary manager evaluation process and selection criteria help us identify what we believe are superior investment managers before they are widely recognized.

In addition, our asset size allows us to negotiate lower fees. We offer our clients access to a carefully selected and closely-guarded group of investment managers that meet our strict performance and qualitative criteria.

[1] MorningStar, 2017

 

Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.

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