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Active or Passive? Understanding the Level of Efficiency of Individual Markets is Critical

Active or Passive? Understanding the Level of Efficiency of Individual Markets is Critical

| September 04, 2019
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At the risk of drilling down into the weeds too much, I thought it would be a good idea to revisit the active vs. passive topic.  Any analysis of active vs. passive management should be conducted on a market-by-market basis. This is because the key determinant of which strategy, active or passive, is most appropriate is market efficiency and there are varying levels of efficiency between and within asset classes, i.e. equities vs. fixed income and domestic vs. international equities.

The active vs. passive question has special implications for you as an investor.  If active managers don’t add value, and utilizing passive funds in order to reduce expenses is in your best interest, then so be it.  Therefore, today we’ll examine several different markets in order to find out which are the most and least efficient. In order to get an idea of the level of efficiency, we will take a look at rolling five-year return rankings to see how several of the most well-known indices (representing passive management) have performed.

Market efficiency describes the degree to which asset prices quickly and rationally adjust to reflect new information.  In a highly-efficient market, any new information is quickly incorporated into prices and therefore it is difficult to consistently achieve above-average risk-adjusted returns in this type of market.  Therefore, due to their lower cost, passive investment strategies are favored over active management in a highly-efficient market. In less efficient markets, on the other hand, the opportunity exists for skilled active managers to outperform passive strategies, thereby adding value for clients.

All too often, the active vs. passive debate examines only large cap U.S. equities, which is a natural starting point for the discussion – the large cap U.S. equity market is composed of the most well-known companies in the world and represents a large portion of many retirement portfolios.  However, the very fact that U.S. large cap companies are the most visible and researched firms in the world suggests that the U.S. large cap equities market is likely to be more efficient than its less-well-known counterparts. And while passive appears to have been winning over the last several years, at least within the U.S. large cap space, and trillions of dollars have flowed into passive index funds, reducing active management’s market share, it might be premature to say the contest has been settled.  

There have been other periods in the past during which active management has underperformed passive for several years only to have the trend reverse.  We cannot rule out the possibility that there have been fundamental changes to the U.S. large cap equity market which will prevent active managers from regaining superiority.  Also, we cannot dismiss the possibility that over the last several years we have simply been in a market environment that favored passive strategies and the pendulum will swing back in favor of active. While we cannot predict what the future holds, we can look at what the current evidence is telling us.

 

 

As you can see, the passive US indices (the S&P 500 SPX and the S&P 600 SML) have performed well as both indices have ranked in the top half of their respective universes over every time period shown.  This means that the average active manager in these markets has usually underperformed the index and indicates these markets have been fairly efficient. In this case, the data shows that it has been difficult for active managers to generate excess returns in these markets and a strong case can be made for passive management.  That being said, we can also see that, most often, neither of these ranks in the top quartile of their respective universes, which means it is possible that there are some active strategies which have outperformed the index.

 

 

Looking at the non-US equity rankings, we see that both the developed and emerging market indices rank in the bottom half of their respective universes over every time period we examine. This tells us that the average active manager in these markets has outperformed the index, adding value for clients, and indicates that active strategies are likely to be preferable in these markets.

 

 

The fixed income rankings show a similar picture to that of non-US equity – both the U.S. and global indices consistently rank in the bottom two quartiles, once again showing that the average active manager in these markets has outperformed the index.  This would seem to indicate that an active strategy is probably preferred for these markets.

So, getting back to our original question – which is the correct strategy, active or passive?  The best answer seems to be, it depends on the market. As we have seen, there are several markets in which the average active manager has usually been able to outperform the index.  We’ve also seen there are more efficient markets in which active managers have struggled to outperform the index.  

Making a market-by-market assessment when deciding whether to employ an active or passive strategy for our clients allows us to save money by utilizing passive strategies in efficient markets, and add value by identifying inefficient markets and selecting skilled managers who can generate superior returns.

As always, please do not hesitate to call me if you have any questions.  And, please share these concepts with others who you think would benefit.

Until next time, Cheers!

Jim

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