By: Gene Walden, Senior Finance Editor, and Jeffrey Branstad, CFA, Senior Investment Product Strategist May 01, 2018
Index funds have traditionally been at their best versus actively-managed mutual funds during bull markets – and that was generally the case throughout much of the current bull market that began in 2009.
But recently, certain actively-managed mutual funds have been staging a comeback versus the indexes and index funds as the end of the quantitative easing era changes market dynamics. While not true of every asset class, we have seen improving comparative performance of active managers in a variety of peer groups, particularly large cap equity funds. (You cannot invest directly in an index, but index funds essentially mirror the composition and performance of a stock index, such as the S&P 500.i)
In fact, the majority of no-load, actively-managed funds in two of the three primary Lipper large cap peer groups have outperformed their respective indexes over much of the past two years, and the other peer group has significantly closed the gap.
The chart below shows comparative performance of three large cap stock peer groups versus their respective S&P 500 indexes from June 30, 2016 (shortly after the Fed started raising rates) through March 31, 2018.
The chart demonstrates the change in relative performance between no-load actively-managed funds and their respective indexes:
- Large Cap Growth. Less than 5% of the 274 no-load actively-managed funds in the Lipper Large Cap Growthii peer group outperformed the S&P 500 Growth index during the five-year period from June 30, 2011 through June 30, 2016. But in the nearly two years since then, about 74% of the 384 funds in the peer group outperformed the index.
- Large Cap Core. Only about 10% of the 300 no-load actively managed funds in the Lipper Large Cap Coreiii peer group outperformed the S&P 500 index during the initial five-year period ending June 30, 2016. But since then, about 43% of the 416 funds in the peer group outperformed the index.
- Large Cap Value. Only about 14% of the 175 no-load actively managed funds in the Lipper Large Cap Valueiv peer group outperformed the S&P 500 Value index during the first five-year period ending June 30, 2016. But since then, about 70% of the 268 funds in the peer group have outperformed the index.
Role Reversal Follows Trend
In 2016, we published an analysis that showed that most actively-managed funds tended to trail the indexes during strong bull markets and outperform the indexes during bear markets, such as the Tech Crash of 2000-2003 and the Financial Crisis of 2007-2009. (See: Active Investment Management Tends to Outperform Passive When U.S. Equity Markets Turn Turbulent)
And indeed, during the bull market years of 2009 to 2015, the S&P 500 index did outpace the majority of actively-managed large cap funds.
But the tide started to turn toward actively-managed funds in 2016 as the Federal Reserve began reversing its policy of monetary easing that had helped drive up stock prices.
As we pointed out in our 2016 analysis, in order to stabilize the economy, “the Federal Reserve launched quantitative easing activities (with low interest rates and a steady increase in the money supply.) All of that extra capital in the system has flowed to equities across the board, boosting market returns while greatly increasing correlations (in performance) among stocks.
“That means that all equities, even stocks that many active managers think are unattractive, have generally gone up together, with higher risk companies that carry more debt on their books actually leading the way as the low interest rates distorted the risks inherent in holding too much debt.”
That’s been a long-running advantage for index funds, since they own all equities in their index – including the more highly leveraged stocks that flourished under the former Fed policy.
Times Are Changing
Because the economy has stabilized, the Fed has begun tightening the money supply and pushing up interest rates through a series of small hikes in the Fed Funds rate. That puts companies with higher debt loads at greater risk of financial difficulties. (See: Assessing the Economy 10 Years After the Financial Crisis)
It’s under these types of circumstances that active managers have the opportunity to provide perhaps their greatest value. While index funds continue holding a pre-determined allocation of all stocks of the index – even the ones with greater potential for financial problems -- active managers can be more selective in their portfolios and work to avoid the potential underperformers. The recent market results tend to reinforce that premise.
Will the Trend Toward Active Funds Continue?
As always, that depends. Past performance does not guarantee future results. Many scenarios could play out that could tilt the pendulum either way. But there have been some recent trends that may bode well for actively-managed equity funds.
The increased volatility in the market in 2018 has already appeared to contribute to the improved comparative performance of active funds versus the indexes. If that volatility continues, or the market spins into a more severe correction, that could play in favor of active managers, based on historical performance.
Even more significant, the Fed is expected to continue to raise rates and tighten the money supply for several more years to come. That could create further disparity in the performance of stocks in the index, and could give active managers an edge up over the indexes because of their option to weed out the higher leveraged stocks from their managed portfolios.
Thrivent Mutual Funds offers a family of 25 mutual funds actively-managed by our more than 100 investment professionals. Investors can choose to build their own diversified portfolio with a combination of Equity Funds and Fixed Income Funds, or let us do it for them with one of our diversified Asset Allocation Funds or Income Plus Funds.
i The S&P 500® Index is a market cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
The S&P 500® Growth Index measures the performance of the growth stocks in the S&P 500 Index.
The S&P 500® Value Index measures the performance of the value stocks in the S&P 500 Index.
ii The Lipper Large Cap Growth peer group is made up of funds defined by Thomson Reuters Lipper as investing primarily in stocks with large market capitalizations and oriented toward growth (generally higher valuation characteristics than the S&P 500 Index, such as price/earnings ratio, price/book ratio, price/cash flow ratio, etc.).
iii The Lipper Large Cap Core peer group is made up of funds defined by Thomson Reuters Lipper as investing primarily in stocks with large market capitalizations and oriented toward core (generally similar valuation characteristics to the S&P 500 Index, such as price/earnings ratio, price/book ratio, price/cash flow ratio, etc.).
iv The Lipper Large Cap Value peer group is made up of funds defined by Thomson Reuters Lipper as investing primarily in stocks with large market capitalizations and oriented toward value (generally lower valuation characteristics than the S&P 500 Index, such as price/earnings ratio, price/book ratio, price/cash flow ratio, etc.).