The poor performance of active managers is not without precedent. As Table 1 shows, it has happened a number of times in the past 19 years. Core plus fixed-income underperformed the BarCap Aggregate by a whopping 8 percentage points in 2008—it’s worst year ever. Small-caps had their second worst year with the median manager trailing the Russell 2000 Index by 2.6 percentage points. International equity active managers posted their third worst year since 1990 while large-cap value managers posted their fifth worst year. And these numbers are before fees.
The impact of the active management shortfall in 2008 is more sobering when we combine these active and passive asset class results into a classic 60/40 stock/bond portfolio. 3 Under this mix, we find that a portfolio of median active managers trailed a passively implemented portfolio by 3.4 percentage points, before fees. This shortfall more than doubled the previous worst calendar year (1998) when the active implementation would have only cost 1.4 percentage points in relative performance (again before fees!).4
Granted, making an assertion about active management with just one year of data is contrary to the “long termism” embedded in our investment culture. However, the cumulative hurdle of higher fees becomes relentless over longer time periods.
We see a silver lining in the aftermath of 2008: The global meltdown in virtually all risky assets has finally brought long-term return expectations to attractive levels. As we have stated in the past, dividend yields comprise the lion’s share of stock market returns over long time periods.5 As of February 27, 2009, the dividend yield on the S&P 500 Index was 3.9%, the highest since the recession in the fall of 1990. This figure is also very close to the historic return from dividends as shown in Figure 1. The premium for bearing market risk (as measured by equity dividend yields) is finally in line with the historical average. If it “pays” to be a long term investor, isn’t it time to take a hard look at equities again?
We believe that last year’s disappointment with active management will likely reignite the active–passive debate in investment circles, and that many investors will come down on the side of passive management. In short, we believe investors will favor simplicity over complexity, lower fees over higher fees, liquidity over lock-ups, and transparency over opacity. Beta exposure can get most investors in the ball park of their long-term return targets, without the risks and costs of active management. The recent headlines will accelerate this trend. How many times has an index fund been indicted for a multi-billion dollar fraud? If investors progressively embrace this view, their allocation to index funds will rise as should their scrutiny on the way these indexes are constructed.
In summary, we believe the recent investment disappointment combined with (finally) reasonable attractive equity valuations suggests advisors and investment committees would be well served to revisit their allocation to passive equity strategies in their portfolios.