Content provided by Michael Hadden, Junior Research Analyst
Now that summer is around the corner, I assume it’s safe to say most New Year’s resolutions have fallen to the wayside. For many, myself included, that resolution involved getting to the gym and being more active. And while I haven’t been great at making it to the gym this year, I have persisted in being active in my financial decisions. I think that counts! I encourage others to consider this twist on an active lifestyle, too.
Investors can be active in a couple of ways. The first is using an active manager to make investment decisions. The second is using active products to achieve superior risk-adjusted returns. Passive investing has clearly worked in the recent past, but there are several trends that point to a changing of the guard. For the four reasons cited below, 2018 could be the year active managers start to regain the outperformance we typically expect.
- Passive Investing Has Had an Easy Ride
Investors could have put their money just about anywhere last year and seen great returns. In fact, the often-referenced 60/40 portfolio (60% S&P 500 Index, 40% Barclays Aggregate Bond Index) has done well since the 2008 global financial crisis. This simple, two-holding portfolio averaged an annual return of about 12%! Why would an investor need an active manager if such a simple and cheap portfolio can gain 12% a year? The gains were nearly uninterrupted, too. As the chart below shows, the portfolio dipped very infrequently over the past nine years.
But returns for passive funds may no longer be so easy to come by. For instance, active ETFs greatly outperformed their passive counterparts in the last 3 months. Now this is obviously a very small sample; but as volatility returns, the decisions active managers make may start paying off again. Most market experts are calling for lower expected returns across nearly all asset classes in 2018. This can make it very hard for a generic portfolio, much like our 60/40 example, to generate solid returns. In fact, the following chart shows CLS Scores* for a variety of assets classes.
As you can see some of the traditional asset classes have some lower expected returns. One of the lowest happens to be the 60/40 portfolio. Some less mainstream assets such as international equities have much higher expected returns. Even an asset class such as commodities has a very similar expected return.
- Active Can Mine Alternative Sources of Returns
In this historic bull market run, most asset classes have moved toward the higher end of their valuation ranges. This leads to the lower expected returns cited above. Thus, moving forward, to achieve higher returns, investors may need to look to other asset classes. One asset class below its historical valuations is commodities. The commodity sector, as a whole, has very attractive valuations. Asset classes at below average historical valuations often have above average returns moving forward.
Allocations to asset classes such as commodities and/or emerging markets could provide investors with the greatest opportunity for outperformance. Broad passive products, such as an S&P index, would not give exposure to these areas. This is where an active manager can take advantage and provide better returns.
- Outperformance is Cyclical
The markets are cyclical, and active management has been underperforming for a while. History tells us that if this trend breaks we may see a prolonged run of active management outperformance. The chart below shows the trend has begun to reverse ever so slightly. As mentioned previously, since the start of February there has been a good period for active products as active ETFs outperformed their passive counterparts by an average of 77 basis points (bps) even after expenses. If outperformance at this level persists, active products would outperform by close to 9% in a single year! It’s no coincidence active outperformance returned simultaneously with market volatility.
- The Power of Behavioral Coaching
It is well documented that investor returns trail total returns due to our human instinct to chase performance. Passive products have performed well, and investors may be content to let their investments run. But what happens when the market isn’t shooting higher? We got a glimpse of this to start the year in ETF asset flows. ETFs, as a whole, saw record demand in January, which corresponded to broad markets having a great month. Subsequently, the first monthly outflows for ETFs in two years occurred in February, corresponding with the first market correction in . . . two years. The idea of passive may be great, but if an investor panics in a market downturn, he or she will more than likely end up as a stat in a behavioral finance study citing investors who continually trail total returns.
Using an active manager can help investors stay calm in volatile markets such as we’ve seen over the past month. Here at CLS, we base our investment philosophy on Risk Budgeting, which aims to ensure clients target appropriate risk levels to achieve their long-term financial goals. With those Risk Budgets in mind, we make investment decisions that allow our clients to perform in a variety markets. As a third-party money manager, we can help prevent investors and financial advisors from acting on emotion when the markets are down. We help weather the storm, aiding investors to reach those long-term financial goals. Something a 60/40 portfolio can’t do.
So, while my gym membership may not be active, and I may not look the best lying on the beach, I’m confident my utilization of active management means I can make it to that beach and enjoy my dream vacation. I encourage readers to give thoughtful consideration to getting active, too, and making the most of your financial portfolio. That’s one resolution you can keep.
*CLS Score: A proprietary expected return measurement CLS calculates as a complement to our Risk Budgeting Methodology. It is constructed by first building a capital market assumption (CMA) for a broad asset class, then adding a valuation overlay, a technical overlay, and a cost adjustment for each ETF. The end result is an expected annualized return (the “CLS Score”) for every ETF we track.