NDW Prospecting: Active vs. Passive in 3Q24 and the Long-term
As we typically do each quarter, today we revisit the debate between active and passive management by looking at how passive indices have fared across several different markets – US large cap equity, US small cap equity, international developed equity, emerging market equity, and US fixed income – over both the short- and long-term.
The key determinant of which style, active or passive, is superior is market efficiency. Market efficiency describes the degree to which asset prices quickly and rationally adjust to reflect new information. In highly efficient markets, new information is quickly incorporated into prices, and therefore it is not possible to consistently achieve above-average risk-adjusted returns in these markets. Therefore, due to their lower cost, investors are better off utilizing passive strategies in highly efficient markets. In less efficient markets, on the other hand, the opportunity exists for skilled active managers to outperform passive strategies, thereby adding value for clients.
The active vs. passive debate often focuses on large-cap U.S. equities, which is a natural starting point for the discussion – the large-cap U.S. equity market is composed of the most well-known companies in the world and represents a large portion of many retirement portfolios. However, if we stop there, we ignore what should be an obvious and fundamental element of the discussion – the various markets around the globe are unlikely to all be equally efficient. The very fact that U.S. large-cap companies are the most visible and researched firms in the world suggests that the U.S. large-cap equity market is likely to be more efficient than its less well-known counterparts! It is because of the variation in efficiency that the merits of active versus passive management should be evaluated on a market-by-market basis.
On the surface, the debate between active and passive may seem academic. However, it has practical implications for advisors. Most importantly, you want to do what is in the best interest of your client. If your client will be best served by using low-cost passive funds because active management truly doesn't add value, then so be it. However, utilizing only passive funds eliminates one of your value propositions as an advisor – evaluating and selecting funds – and removes any possibility of outperformance, so, from a business perspective, it is probably preferable to keep at least some active management in the mix.
The tables below show the quarterly, year-to-date, and rolling five-year return rankings of several well-known indices (representing passive management). If the index ranks in the top two quartiles, then it outperformed most managers within the peer group during that period. Conversely, if the index ranks below the 50th percentile, then most active managers in that universe outperformed the benchmark. Looking at the rankings over time, we can get a feel for which markets are the most efficient, and therefore likely to favor passive management, and which are the least efficient, and therefore provide the greatest opportunity for active managers.
The earliest five-year period in our long-term rankings began in June 2020 and the most recent period ended September 30, 2024. During that time, we have experienced several different market environments and market-shaping events from the calm of 2017 to the volatility of 2020 and the monetary policy-driven drawdown of 2022. So, we have a good cross-section of market states, and how each management style performed therein, upon which to base our conclusions.
US Large Cap
The S&P 500 (SPX) finished Q3 below the 50th percentile, a departure from the recent trend. Participation improved in Q3 and smaller sectors like utilities and real estate were among the top performers, allowing managers who allocated away from areas like technology and comm services to outperform the benchmark. Over the longer-term, however, the S&P 500 has been a difficult benchmark for active managers as the index has ranked above the 50th percentile in every 5-year period in our lookback window.
US Small Cap
The Russell 2000 (RUT) outperformed most active managers in Q3, finishing above the 50th percentile for the first time in 2024. The index remains in the third quartile on a year-to-date basis. Over the longer-term active managers in the small cap space have fared much better against the benchmark than their large cap counterparts as RUT has ranked below the 50th percentile over the last 13 rolling five-year periods, often finishing in the fourth quartile.
International Developed
The MSCI EAFE Index (EAFE) finished in the third quartile during the most recent quarter, the first quarter this year it has fallen below the 50th percentile. Over the longer-term, EAFE has hovered around the mid-way mark, finishing some rolling five-year periods slightly above and some slightly below, showing no obvious bias towards either active or passive management.
