The debate over Active and Passive fund management

Many articles have been written on the active versus passive fund management debate. At Optimum, we believe that there is merit in both strategies. Combining the two strategies will decrease a fund’s overall cost and it can increase the returns.

In this article, we will explore whether certain market conditions are more suitable for active or passive investment.

On average, active managers have struggled to outperform the ALSI over the last couple of years. The chart above shows that historically managers delivered stronger excess returns when markets were down.

In this article, we explore whether active management results are related to dispersion, volatility and market returns.

Dispersion is a measurement used to calculate the breadth in security returns. A wide dispersion implies that there is more room to select stocks that will outperform and skilled managers should be more likely to generate alpha. Lower dispersion or greater uniformity may dampen the potential for outperformance.

To visualise the conditions in the market over time, we rank them by quartiles. For example, quartile 1 comprises of the 25% of periods exhibiting lowest volatility (or standard deviation or market returns)

In the graph below we plotted the alpha of active managers (orange bars) against the returns of the ALSI. There is a clear inverse relationship between the market return and the outperformance by the average equity manager. The outperformance is the highest when equity market returns are the lowest (quartile 1 returns). However, since 2014 it seems like this relationship has broken down. The ALSI was stuck in quartile 1 returns, but the average equity manager underperformed.

Similar graphs for standard deviation and dispersion provides us with additional information. Active managers have underperformed since 2011. This is a period in which the ALSI experienced very low volatility and below average dispersion.

During the past two years, we see that the dispersion has increased but the overall volatility remains muted.

From the above graphs, we see that the best periods for active managers were during 2001 – 2004 as well as 2008. These periods can be characterised by low equity market returns, high standard deviation as well as high dispersion in returns. It seems like this is the best market environment for active managers.

Over the last two years all the characteristics were in place for active managers to outperform except for volatility.

Conclusion

We believe that active and passive managers have a role to play in portfolio construction. From the above analysis, we can conclude that certain environments are more conducive for certain strategies. Combining active and passive managers can therefore lead to better performance.