Actively Going Passive, but at What Cost?

So what does a positive environment for active management look like? Our observations and numerous studies have generally indicated that active approaches tend to perform better when:

• Smaller capitalization companies are outperforming (active portfolios tend to have lower average market caps than passive indexes, in part because equal weighting rather than market-cap weighting is the preferred portfolio construction approach).

• International companies are outperforming U.S. companies (most domestic equity portfolios have some exposure outside of U.S. markets for a variety of reasons).

• Value stocks are outperforming growth stocks (active managers tend to focus on valuation).

• Overall stock market returns are more subdued (active managers almost always have a cash drag they have to battle).

• Correlations between stocks are lower (meaning there are more stock specific factors driving returns).

With that in mind, how do these three-year periods compare on those measures? The table above shows that on every measure, the three-year period ending in June 2011 was much more favorable to active management than over the three-year period ending in June of this year. To be fair, this simple comparison is not the same as a statistically rigorous study, but the results do echo what we've seen, as well as what we've experienced while managing money over time.

So at what expense are investors throwing in the towel on active management? I guess it depends on one's outlook. Is it likely that the largest names will continue to outperform? Is it likely that U.S. equities will dominate over the coming years? Is it likely that value stocks will remain the underappreciated little brother of growth stocks? Is it likely that equity markets will put up large returns in the coming years? Is it likely that stocks will continue to move as a herd, rather than based on individual fundamentals?

Mean reversion can be mean, and it's a powerful force in markets. We'd hazard a guess that the tide will soon turn on many of these trends, and with it, investors will inevitably question why they gave up on active management. When everyone is doing the same thing, the payoff diminishes. We'd suggest that you think about how you'd like the conversation with your client to go three years from now, and plan accordingly.

— Read 'Pundits' See More ETF Growth; Reduced Active Management on ThinkAdvisor.