In the rush to index, high active share could, paradoxically, be a way to cut volatility.
Some see the steady migration into equity index vehicles as the death knell of active management; others see a potential contrarian opportunity. My colleague Shannon Zimmerman made this point recently. But this opportunity isn't just for the intrepid looking to outrace the market. In this era of diminished expectations, some risk-averse investors may care more about reducing volatility without abandoning equities entirely. Such investors may worry more about the increased equity correlations and market risk that have accompanied rising passive inflows. These days, as markets increasingly move in synch, some actively managed funds might actually offer better risk-reduction than some ultradiversified index funds.
The landscape for United States stocks funds in particular has changed dramatically over the past decade. The tilt toward passive management is well-documented, but the staggering numbers are worth reviewing. More than $550 billion, or 20% of beginning assets, left actively managed U.S. stock funds from May 2006 through July 2012. Over that same span passively managed vehicles--both open-end funds and exchange-traded funds--collected more than $350 billion. Passive fund market share has roughly doubled over the past 10 years to one third of U.S. stock fund assets. As of July 2012, total assets in passively managed U.S. stock funds stood at more than $1.2 trillion. Momentum has only accelerated in recent years as $135 billion has left actively managed U.S. stock funds over just the past 12 months, while passively managed funds have collected $65 billion. The trends are broadly similar for foreign-stock funds.
All Colors Bleed Into One
The problem with the increasing popularity of index funds is that it could blunt some of their advantages. To be sure, the case for index funds is very compelling. They offer low costs, broad diversification, and generally competitive risk-adjusted returns versus category peers with minimal manager risk (that is, the risk that a fund manager underperforms his or her index).
But flows into passively managed funds have arguably diminished the benefits of diversification and increased risk in equity markets. In a paper published this spring in the Financial Analysts Journal, Rodney Sullivan at the CFA Institute and James Xiong, a colleague at Morningstar Investment Management, argue that ETF trading in particular has contributed to increased correlations among stocks as they increasingly trade as part of index baskets rather than individually. They estimate that ETF trading now accounts for roughly one third of all trading in the U.S.(1)
Sullivan and Xiong found that the average beta (a measure of market volatility) increased across all equity segments from 1997 to 2010. Just as significantly, betas across market caps (large versus small) and styles (value versus growth) have also converged over the past 10 years. As a result, not only have betas risen over the years, but diversification benefits across market cap and style have diminished. Crucially, Sullivan and Xiong also found "a meaningful relationship between passive investing and a rise in market risk as proxied by various market betas." This isn't to argue that passive inflows are the only culprit. Other factors are likely at work. But investors shouldn't fool themselves into believing that diversification alone can shield them from market downturns.
The Active Among Us
These trends could create an opening, though, for actively managed U.S. stock funds. With U.S. stocks increasingly moving together, funds that look less like the most-popular indices--as defined by active share--may be in a better position to weather market swings. And with overall market volatility increasing, it arguably makes sense these days to define risk more in absolute terms, as many truly active funds do, rather than in relation to an index. On the other hand, no equity fund can avoid market risk. If U.S. equity markets seize up, all equity funds will feel the pain. However, some funds may be in a better position to mitigate the damage than others. In this case, looking different from the market is less about outperforming on the upside than on protecting on the downside.
There are a number of funds that are just as dedicated to providing downside protection as they are to differentiating themselves from the index. For this article, we limited ourselves to the large-blend category since it's home to $800 billion of the $1.2 trillion in passively managed U.S. stock assets, most of which is tied to the S&P 500 index. To find those funds best suited to capital preservation, we looked for offerings with high active share (a holdings-based measure of differentiation from the benchmark), a reasonably well-diversified portfolio (putting aside for a moment the debate over whether concentrated funds are more or less risky than their better-diversified brethren), and low downside capture.
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