While Morningstar VP of Research and longtime fund industry expert John Rekenthaler has held a positive view on active investing over the years, he accepts the overwhelming evidence of the benefits of passive investing. “I am convinced by the argument that expenses matter and index funds as a group being lower cost will outperform the typical actively managed fund,” Rekenthaler says. “There are a huge number of actively managed funds and they do tend to cancel each other out. Some do better than the market, others do worse; overall they have higher costs and therefore they are going to trail the pool of index funds as a general rule.”
This does not stop Rekenthaler from looking for those all-stars that do outperform their benchmarks. “Certainly there are individual funds that perform better. Of course, the trick is to be able to identify them ahead of time,” he says. “That seems to be easier to do in some areas of the market, such as with international investing than it is in others, such as U.S. large-cap.”
In fact, Rekenthaler points out that the growing assumption that passive investing always outperforms active investing is really a U.S.-based phenomenon.
“When you look overseas, there are many international funds that have consistently outperformed the relevant indexes,” he says. “Part of it is they had a different exposure to Japan and emerging markets (see “Beating the number,” below). However you want to slice it, the average international stock fund manager has done better against the indexes than U.S. fund managers do against an index.”
Rekenthaler points out that where U.S. active managers have shined is in making bets on smaller company stocks, which is why the times active managers score high are generally when small-caps outperform the broad market. Active managers also tend to do well with lower turnover strategies that tend to have a value element, according to Rekenthaler. “As a group they are going to benefit from small companies outperforming. The handful of managers that would be expected to outperform tend to be lower turnover value funds, boutique funds,” he says.
Rekenthaler says it is possible for active managers to outperform their benchmarks over a long period of time but is not convinced that a changing interest rate environment would spark such a shift.
Some analysts have floated the idea that active managers could have a Renaissance of sorts when the Federal Reserve finally begins to move interest rates higher because they performed well in the 1970s when rates were raised to fight inflation.
“We haven’t had [rising interest rates] in a significant way since the 1970s. It depends on how high they rise,” he says, pointing out the obvious that rates were aggressively lifted to the upper teens in the 1970s to combat inflation and currently even the most hawkish Fed watcher doesn’t expect rates to be lifted from their zero-bound level by much more than 1% per year.
He also points out that there were other factors at play. “In the 1970s we know active management did very well relative to the large-cap indexes because small company stocks dramatically outperformed large companies,” he says, adding, “That is generally the way active management beats the major indexes. Because active managers, even in funds that are labeled large company funds, tend to underweight the biggest stocks in the index. In that environment when small company stocks thrive, active management will thrive. It is true that active management still may not look incredible relative to small-cap indexes but that is not typically how they are measured, and people don’t own those small-cap indexes when they index,” he says.
In fact, that is what has benefited active management in Europe, says Rekenthaler. In Europe indexing is much less popular than in the [United States] for a variety of reasons, one big reason being that active managers have performed much better.
He notes that active managers tend to beat the individual country stock indexes in Europe (see “Staying active,” below). “In the United Kingdom the typical actively managed UK stock fund has beaten the FTSE Index during the last 15 years. In Europe, small company stocks have really thrashed the big company stocks and active managers have had more exposure to them and have benefited from that.”
Endless bull market
Of course, a rising interest rate environment is not the only characteristic of market fundamentals that could change. The preeminence of passive investing corresponded with the creation of investable benchmarks which also corresponded with the long bull market that began in the early 1980s. The 1970s were not only a period of rising interest rates but were also characterized by relatively flat performance in equities. Many active proponents see a return to this type of cycle as benefiting active management.
Here Rekenthaler once again finds an alternative reason. “Active managers tend to say that is the type of environment that works well for them but I haven’t seen the evidence of that over history,” he says. “The 1970s were a churning market for large-cap stocks but there wasn’t a churn for small-cap stocks; small-caps just went up and that is what helped the active managers. But when the markets have been up and down, I don’t necessarily think that helps active managers.”
Rekenthaler doesn’t see overall market performance being a major factor in whether active or passive investments perform better. “If you look at various choppy markets in the past, the percentage of active managers who outperform passive isn’t that different in a bull market. Definitely in a bear market the percentage of active managers tends to go up. It didn’t work too well in 2008 but it did in previous bear markets,” he says, adding, “Bull markets make indexes look better because they are 100% invested and the competition is not, [but] the percentage of active managers who outperform is not that different in a bull market or bear market.”
He does acknowledge that there may be more incentive for investors to reach out to active managers in flat or bear markets. “I am not convinced that [the] average active manager in a flat and choppy market will beat the index but investors may be convinced of that and may be more [motivated to] find an active manager. If they believe that the indexes aren’t going anywhere, owning an index fund isn’t very attractive.”
However, he adds that the real beneficiary of those poor equity environments will not be actively managed stock funds but rather other assets. “Given that assumption, alternatives would make a lot of sense,” he adds.
What is active?
Of course, with the explosion of new products, numerous exchange traded funds and the concept of “smart beta,” defining what is active and what is passive has become somewhat murky.
There are several indicators that attempted help determine if a fund is truly active or if it is simply a “closet index.”
Among these are Active Share, R-Squared and Turnover Ratio. Rekenthaler uses them all and finds them useful, but not without flaws. Active Share is pretty simple in that it measures a manager’s portfolio versus its benchmark. The less commonly held stocks, the higher the Active Share.
“If you are talking traditional active managers, Active Share could be a very good tool in getting at them,” he says. But he adds, “It is not perfect. For one thing if you form a portfolio and you control for industry exposure, you can have a reasonably high active share, but it could look exactly like the index. You leave out Pepsi but you double up on Coke, you leave out John Deere but you double up on Caterpillar. If you control for your industry exposure, you are going to look a lot like the index.”
He points out that index funds can have relatively high Active Share.
“They’re all good. I would probably rely on tracking error and R-Squared more for telling me what is active than Active Share, but sometimes Active Share is better,” he says.
In the end, he used a combination of R-Squared, Active Share and tracking error but there is no one measure he relies on. “Not many people besides some geeky fund researcher are going to do this, but in combination, fund analysts are going to have a pretty good sense of how active a fund is.”
Apples to apples
Rekenthaler points out that while there is no guaranteed method for picking those active managers who outperform, the same can be said for passive funds.
“Picking indexes is an active decision. If you talk about potential drawbacks, we talk about how the average passive fund will beat the average active fund but you don’t own the average passive fund,” he says. “Maybe you get the underperforming subset. You can’t go out and buy the average. People think if you pick an active fund you might be stuck with a lemon, but you can be stuck with a lemon in passives too.”
He adds that this is particularly true with small company indexes that don’t track as well as broad market indexes. “When you get into small company indexes: A Russell 2000 vs. a Wilshire Small Company vs. an S&P 500 (small-cap), there’s quite different behavior,” he says. “Owning passive funds doesn’t avoid the problem of picking the wrong fund.”
As for “smart beta”, Rekenthaler likes anything that increases investor choice and provides price competition. “The effort to create beta everywhere makes sense from an investor point of view. I like to have another option, plus it causes price competition and forces active management to think about their expenses,” he says, while adding, “That doesn’t mean they make the best investments.”
Rekenthaler acknowledges that is there is little value in asserting active managers’ ability to outperform if that outperformance is totally random, and he has thoughts on how to find the best.
“We know lower cost is a help for active funds as well as passive funds, and we know that lower turnovers tends to be a help,” he says. “I would add to that a large degree of manager ownership, where the manager tends to own a larger amount of the funds they invest in.”
He adds an investment culture that would allow this and not be focused on hitting short-term targets.
In the end, for Rekenthaler, expenses are where passives get their edge.
“If you subtract out fund expense ratios the pool of active funds pretty much matches an index. So, basically fund managers are matching the performance of the index before expenses, even including a little drag of trading cost, which implies that overall they are making slightly superior trades,” he says. “So [active managers have] some insight but with the cost of trading and the cost of running the fund any value added quickly gets eaten up.”
Which begs the question: At what price point would the active manager’s skill overcome the higher cost structure? “I don’t know exactly, but something around 30 basis points,” he says. “They tend to come in at 100 basis points and they tend to be 60 or 70 basis points high.
As for Rekenthaler’s own portfolio: He is invested in some active managers including alternatives as well as owning Berkshire Hathaway.