Why active vs. passive isn’t an either/or choice

Part 2: Exploring the truth about benchmark investing

Why active vs. passive isn’t an either/or choice

Life is full of undeniable truths. There’s, “An apple a day keeps the doctor away.” Another old favorite is, “Don’t judge a book by its cover.” And for years, investors have been trained to trust in market averages. Over the long term, the saying goes, you can’t beat the market — so why not join it through a passive investment strategy that mirrors exposure to a market benchmark?

Apples are surely nutritious, and reading a book before judging it is definitely prudent, but when it comes to investing solely in market averages, we need to talk.

In this series, we are examining some common myths about benchmark investing. Our last blog covered the basics about what benchmark indexes are. Today, we uncover the facts on how outperformance can swing between active funds and passive funds that track those benchmarks — information that we feel can be critically important when building a portfolio for the long term.

Is investing solely in broad-market benchmarks always a good idea?

We believe the answer is no, and here’s why. Investment performance, like the economy in general, is cyclical.

There are times when different types of companies tend to excel. For example, consumer discretionary and financial companies may outperform early in an economic expansion, while utilities and consumer staples stocks may pull ahead once the expansion begins to slow. What may not be as well known is that passive outperformance and underperformance seem to occur in random cycles. In the table below, you can see how each has led or trailed over the past 25 years.

Simply put, investors who have exposure only to passive benchmark strategies may miss out when active strategies outperform.

Active outperformance vs Passive outperformance

Source: Callan, as quoted by Leuthold Group. Active is represented by Callan’s active large-cap domestic managers. Passive is represented by the S&P 500 Index. The “to present” reference includes data through 1Q 2017. Gaps in the time periods shown represent neutral results where no clear leadership between active and passive managers was evident (approximately half outperformed and half underperformed).

Investment returns and human behavior

So, why not just time the cycles and jump from active to passive and back again as the tides change? If you had a crystal ball, and knew exactly when the cycle was going to turn, maybe that strategy would work. Otherwise, a “strategy” of chasing performance is doomed to fail. The chart below illustrates this concept with data from Morningstar.

Investor flows followed performance

Source: Morningstar. Performance data as of Oct. 31, 2016. Flows data as of Sept. 30. 2016. The “US large caps” results are represented by an aggregate of Morningstar’s large blend, large growth and large value categories.

By examining flows into passive and active mutual funds, you can see how periods of outperformance in both attract a larger and larger share of investor money. However, the majority pursue the hot strategy late in the up cycle and also tend to exit late. This pattern of activity can result in investors buying high and selling low.

Could active funds be ready to lead again?

We’re currently in a multiyear cycle of passive outperformance, as shown in the chart above. But evidence suggests that the tide may be turning. A Leuthold Group study1 found that between 1991 and 2016, passive was the best choice when the 25 largest-cap stocks in the S&P 500 were outperforming along with the growth sector. Conversely, when value was in favor and a broader range of S&P 500 large caps outperformed, active management did better. And based on quarterly measurements since 1991, periods of small-cap outperformance have been correlated with overall active management outperformance.1

Given that we saw value overtake growth and small-cap stocks outperform by a large margin in 2016, we believe we could be poised for active fund resurgence as well. 

Chasing hot sectors is not a long-term strategy

Investors who trade by following the crowd risk crippling their financial health. Rather than chase the leading hot sectors or industries, we at Invesco believe in creating a high-conviction portfolio tailored to your unique circumstances and needs. Such a portfolio can include both active and passive strategies, providing the potential to benefit from each without chasing trends.

1. “Active vs. Passive: A Three-Club Headwind,” The Leuthold Group, July 26, 2016

Important information

Blog header image: Aleksandr Simonov/Shutterstock.com

An investment cannot be made directly in an index.

Past performance provides no guarantee of future results.

Tracy Fielder
Product Management Director
Strategist — Rethinking Risk

Tracy Fielder is a Product Management Director for Invesco covering US Value strategies. He works with Invesco’s US Value investment teams and client portfolio managers to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to his product management responsibilities, Mr. Fielder is part of a team that develops the themes, researches the data and presents the concepts of Invesco’s Rethinking Risk program. This educational program seeks to encourage a holistic view of risk, considering market history, investor psychology/behavior, and asset allocation theory/application. This program also looks at the impact of risk parity, a portfolio construction approach that diversifies across sources of risk in relation to various market and economic environments.

Prior to joining Invesco in 2010, Mr. Fielder was vice president of Investment Research at VALIC (Variable Annuity Life Insurance Co.), responsible for leading a team of analysts overseeing the selection and monitoring of all mutual fund managers and sub-advisors utilized for defined contribution retirement plan clients. Before joining VALIC, he was an account executive at Van Kampen Investments where he was in charge of marketing and sales for the Van Kampen mutual fund product line distributed by Morgan Stanley Dean Witter financial advisors. He entered the financial industry in 1993 as a marketing coordinator for PaineWebber.

Mr. Fielder earned an MBA from Houston Baptist University and a BBA, cum laude, with a concentration in finance from the University of Houston. He holds the Series 6, 7 and 63 registrations.


Marie Jordon
Senior Product Manager

Marie Jordon is a Senior Product Manager for Invesco. She works with a number of Invesco’s fundamental equity investment teams to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to her product management responsibilities, Ms. Jordon works on a team dedicated to Invesco’s Rethinking Risk thought-leadership program. The Rethinking Risk program articulates Invesco’s holistic approach to risk, by considering market history, investor psychology and behavior, and asset allocation theory and application. The program also discusses the merits of diversifying portfolios across sources of risk in relation to various market and economic environments.

Ms. Jordon assumed her current role in 2009. From 2002 – 2009 she worked as an investment services analyst working with Invesco’s subadvised, offshore and institutional clients. She entered the financial industry in 1999 when she joined Invesco, working in the retail distribution channel

Ms. Jordon earned a B.B.A. in Marketing from Texas A&M University in College Station. She holds the Series 7 and 66 registrations.

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