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Rekenthaler Report

What Could Go Right for Active Management

A market bubble would be nice.

Bad News Bears
Wednesday’s column laid out a dire future for active fund managers. They currently are attracting only one third of net fund inflows (counting both traditional funds and exchange-traded funds). What’s more, their two areas of sales success, international-stock funds and target-date funds, are under siege. Because of strong performance over the past decade, as well as fiduciary concerns with 401(k) plans, index funds are gaining market share in those two sectors.

However, as several readers have pointed out via emails (please feel free), I might be wrong. Always true, and a particularly apt admonition for that column, which ventured into the perilous field of forecasting.

Yes, active managers might reverse the trend. The likeliest way would be to dodge the puncture of a market bubble.

Severely mispriced markets are a problem for passive investing. (In theory, individually mispriced securities could also be trouble. If half of a marketplace is priced far too low and the other half far too high, then conceivably active-fund managers could purchase the low half, leaving the overpriced fare for other, less-sophisticated buyers. But that doesn’t seem to occur in practice.) As a bubble expands, the frothiest securities grow ever larger within an index.

Examples include Japan circa 1990 and U.S. technology stocks a decade later. Both afforded active managers the opportunity to shine.

Entering the '90s, international-fund managers were poised for relative success. In December 1989, the leading foreign-stock index (MSCI EAFE) held 60% of its assets in Japanese stocks, which sported a sprightly average price/earnings ratio of 68. Every active manager, naturally, gave a severe underweighting to Japan. That gave them a win-win. Either Japanese stocks would return to earth, in which case the active funds would beat the index, or Japanese stocks would not, in which case the active funds could (justifiably) tout their prudence.

The U.S. New Era rage was not as clear a victory for active fund management. Technology stocks became very expensive indeed, but they grew to become only 33% of the U.S. stock market--a figure that many active funds matched, and several exceeded. Nonetheless, almost every self-styled value manager was light in technology, as were hedge funds. Both groups burnished their reputations when technology stocks plummeted from 2000 through 2002.

While a market crash is required to pop the bubble and release active managers’ period of outperformance, a crash alone is not a sufficient condition. After all, active management’s fortunes were damaged rather than improved by 2008's plunge. For active managers to benefit, the bubble must occur within a market segment. Japan was a segment for international-stock funds, and technology for U.S. stock funds. When those two segments suffered, many others thrived. In contrast, everything went down at roughly the same rate in 2008.

The other requirement, of course, is that active funds have a dramatic underweighting in that segment. It does no good if they own the bubble.

The second requirement makes an imminent victory for active stock-fund managers improbable. While nearly all managers were light on Japan in 1990 and about half had a sharp underweighting in technology in 2000, today’s stock fund managers are not positioned much differently from the overall marketplace. Domestic-stock funds are fairly close to the indexes with their U.S. sector weightings, as well as in their investment styles. Similarly, international-stock funds are not far from the indexes’ regional or country weightings. If a market crash drags down passive funds, active funds surely will not be far behind.

(That active stock funds might escape by retreating to cash or bonds can be dismissed. Each bear market, whether in 1973-74, 1987, 2000-02, or 2008, featured a handful of mutual fund heroes. But it was only a handful--and, to my knowledge, not a single hero ever repeated the feat the next time around. Often, in fact, their funds have been shuttered by the time of the next decline, as bear-market stars tend to stay defensive, miss the next rally, and suffer redemptions that lead to their closing.)

There is, however, a possibility for bond-fund managers. In aggregate, taxable-bond managers hold much fewer Treasuries and government-agency bonds than does the Barclays U.S. Aggregate Bond Index, the most common benchmark used for taxable-bond funds. This is nothing new; active managers were similarly positioned entering 2008, and they were punished when Treasuries were the top performers. Nonetheless, if interest rates were to rise dramatically, thereby decimating Treasuries, active taxable-bond managers might regain the initiative.

Thus, while it seems unlikely that active stock managers will soon improve their relative fortunes, bond managers have a real chance. And of course, stock market conditions can change. A few years out, there may once again be an expensive, eagerly discussed segment that active stock managers avoid to general acclaim.

Another reader theme in response to Wednesday’s column was that active managers’ performance woes have been greatly exaggerated.

Writes Morningstar’s Gregg Wolper, "Your American Funds example [I had pointed out to Gregg that every American Funds stock fund with a 15-year record has beaten its relevant index over that time period] supports the point. If clear long-term index-beating performance by a bunch of funds isn’t turning the tide, doesn’t that mean that the problem for active management is clearly a perception issue, not a performance issue?"

Gregg then passed along a recent study claiming that winning mutual funds do not repeat. That paper arrived at its conclusion by evaluating fund returns over one two-year period. In other words, the author knew the conclusion before beginning the article. As Gregg points out, active management would be mocked if it advanced its argument using such limited data. Not so with indexing. These days, indexer marketers need not be rigorous; their claims are accepted virtually without challenge.

Agreed. But it’s hard to see what will alter that perception advantage. The prestige accorded to index funds increases each year. Meanwhile, active funds retreat further into silence. (The exception being American Funds, which a year ago published an extensive report on the performance of active stock fund managers, using 75 years' worth of data.) To improve their reputations, active funds would seem to need a performance jolt. Fair or not, that strikes me as the cold reality.

Finally, in a related argument, Don Andersen disputes the usefulness of the passive versus active discussion because investors do not buy every mutual fund, or anything close to that. They can cherry-pick from the best available choices as opposed to purchasing an average. (Morningstar’s Gregg Wolper says the same.) Writes Don, "I don't refer to the [boutique active managers that I use] as active or passive but rather value-focused and shareholder-friendly. They beat the pants off the passive managers over time because they are better in downturns and good enough in the upturns."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.