This week’s chart examines the ongoing shift from actively managed to passively managed U.S. equity allocations. While active investing has historically been the predominant form of portfolio management, investors are increasingly recognizing that passive strategies are an efficient manner of capturing market beta. Within U.S. equities, the theme of fund flows migrating from active to passive has been dramatic over the past several years. Since 2007, passive strategies benefited from consistent fund inflows while active strategies continually dealt with fund outflows. With the exception of 2013, actively managed U.S. equity strategies saw net fund outflows over every calendar year since 2007. This trend continued during the first quarter of 2016 with outflows from actively managed U.S. equity strategies totaling $44.7 billion and flows of passively managed strategies gaining $27.1 billion.

Investors often view U.S. equities as an efficient asset class for which the case for passive management is the most compelling. Based on fund managers’ stated prospectus benchmarks, only 21% of large-cap U.S. equity funds who benchmark against the Russell 1000 index outperformed their index over a trailing 10-year period. Within small-cap where informational inefficiencies are greater, 52% of funds who benchmark against the Russell 2000 index outperformed their index over a trailing 10-year period. Given that the majority of actively managed funds often underperform their stated benchmarks and charge higher fees in the process, it should come as no surprise that investors are gravitating toward passively managed funds. While active managers who can generate excess returns over time are certainly desirable, identifying those consistent generators of alpha can be quite challenging, especially for efficient markets like U.S. large-cap equities.

This week, we take a look at down market captures (DMC) relative to top, middle, and bottom tier managers for U.S. large-cap equities. Down market captures illustrate how active managers perform during periods of negative benchmark performance. In this case, we are comparing the last 12 years of rolling 1-year down market captures for U.S. large-cap core managers who feature the S&P 500 index as their primary benchmark.

Theoretically, passive management is less beneficial than active management in down markets as passive management will capture 100% of the index returns during the negative periods. In examining the median manager down market captures (red line in chart), we see that the majority of the time active managers are able to outperform the benchmark in times of market declines (a reading below 100 indicates that the manager lost less than the benchmark).¹  This is more evident when looking at the DMCs of managers in the 25th percentile. These managers are consistently outperforming the benchmark during the down market, and losing less capital for their investors. Managers in the 75th percentile consistently have DMCs greater than 100%, meaning they captured more than the negative performance of the benchmark, thus failing to protect in a downside market.

Given the overall efficiency of the U.S. large-cap equity asset class, many investors have moved away from active management over the last five years. And while this trend is not likely to reverse itself anytime soon, those who have identified above median managers may face less downside risk in the event of a market correction.

¹It should be noted that outperforming the benchmark in times of market drops does NOT equate to positive returns; the manager just loses less than the benchmark.

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient.

While the average active manager underperforms the market after fees, there are both successful and unsuccessful managers within the herd. The above table includes a sample of the results from a research study titled “Active Share and Mutual Fund Performance” by former Yale and NYU professor Antti Petajisto. The results of the study indicate that a specific subset of active mutual fund managers, specifically those with high Active Share, have exhibited persistent relative outperformance on a net-of-fees basis.

Active Share is a measure of how different a portfolio’s positions are from those of the passive index. The results of Petajisto’s study suggest that, on average, managers with high Active Share (i.e., Concentrated or Stock Picker type) outperform active managers with low to moderate Active Share. In fact, managers with both high Active Share and lower portfolio turnover actually outperformed the passive index net-of-fees by an average of 1.26% per annum with only slightly higher than average tracking error. A reasonable interpretation is that managers can be successful if they take active positions in strong companies and maintain conviction over time in those investments, avoiding excessive turnover. Meanwhile, managers with the lowest Active Share, termed Closet Indexers, persistently underperformed despite having the lowest fees and greatest diversification. This is unsurprising because these managers act mostly like the index but still charge fees reflective of active management. It is notable that large-cap stock strategies are more commonly closet indexers than small-cap strategies, and funds with too many assets under management have operational inability to take high active share.

In summary, there is a place in many portfolios for both active and passive management. The data does not indicate that all managers with high Active Share will outperform. Nevertheless, evaluating a manager’s Active Share in combination with other qualitative and quantitative factors can be very useful. Through due diligence, an independent investment consultant can help investors distinguish active managers who are more likely to exhibit talent and conviction. More importantly, if investors in so-called closet index funds were to move 60% of their money to a high Active Share manager and 40% of their money to a passive strategy, they could achieve the same level of Active Share while decreasing fees and increasing expected alpha. Take caution though: only patient investors who are comfortable with short-term tracking error can expect to realize the benefits of Active Share strategies, a virtue not exhibited by all.