Is Now the Time to Move to Active From Passive in U. S. Equities?

I had the opportunity this past Monday to attend the Opal Financial Group’s “Investment Consultants Forum”.  There were many interesting topics covered during the day, including my session on “Asset Allocation Strategies in a Volatile Market”. However, there seemed to be outsized interest in the active versus passive discussion, especially as it related to U. S. equities.

I listened intently to the discussion, as I’ve been a student of the markets, products, cycles, etc, for much of my 33 years in the business.  I was disappointed by the responses that I heard, especially from one consultant who “favored” active because their firm can pick superior “alpha generating” managers on a consistent basis.

I did not hear one consultant address the real issues related to why active and passive approaches both make sense depending on the environment, and how active managers are influenced by their own portfolio construction biases.

Most active managers (there are always exceptions) have a value tilt to their stock selection criteria / factors, tend to build equal weighted portfolios, which creates a small cap bias vis a vis the large cap indices, and they maintain some residual cash, even if they aren’t making an asset allocation call.  Given these portfolio construction biases, it is fairly easy to understand that active managers aren’t going to perform well in strong up markets, favoring mega cap firms, which is where we’ve been!  The passive index benefits from being fully invested, and the large cap bias (market weighting) is further fueled by the momentum (non-value indicators) driving the these large cap stocks and the markets.

As you can imagine, these trends are further exacerbated by strong positive cash flows into the recently better performing segments of the market, whether that be retail or institutional money, as neither group exhibits an ability to be a Contrarian.

Given the portfolio construction biases that exist, what is likely to happen in the passive / active relationship in the next 1-2 years? We believe that it is time to reduce one’s exposure to passive strategies (not eliminate), as we see small and mid cap stocks leading the US markets in the near-term.  Why? First, the strengthening US $ will negatively impact the earnings and profits of US mega cap companies that derive a meaningful percentage of their revenue from overseas activity.  Second, large cap stocks (S&P 500 as proxy), fueled in part by the aggressive move into passive approaches, have beaten small cap stocks (R2000 as proxy) by 9+% in the last 12 months, and have performed in line for the last 10 years, despite small cap stocks supposedly being more risky and less liquid (where’s the compensation?).

We would suggest that you move your large cap allocation to the bottom of your target range, while increasing small to mid cap to an overweight exposure.  Furthermore, if you have a target allocation for both active and passive exposures that you shift more assets into active US equity approaches at this time.  After 6 years of US equity strength, large cap dominance, a strengthening $, and a slight style outperformance by growth versus value, we think that the time is right for active managers to begin to add value, while benefiting from the biases that they create in their portfolios.

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