Active Management Won This Battle

One of the biggest battles and continued fights among market pundits remains whether or not indexing or active management is the best choice for investors’ portfolios. Historically, passive has run the roost. When he launched Vanguard and the first S&P 500 index, Jack Bogle argued that broad index funds not only offer plenty of diversification but, thanks to their lower costs, would continue to eat active’s lunch for the long haul. Bogle’s assertion was right on the money. And with the creation of ETFs, the effect has been heightened.

But investors may not want to fly the white flag for active management just yet. Last year was a good showing for active management.

According to Morningstar and its Active/Passive Barometer, most U.S. active stock funds managed to beat their passive benchmarks. All in all, on average, 62% of all active U.S. funds managed to beat their indexes. Some segments did even better. According to Morningstar, small-cap value managers were superstars, with more than 80% beating both the Russell 2000 and Russell 2000 Value indexes.

Even large-cap active funds—which have historically been poor performers versus indexes and receive most of pundits’ scorn—managed to pick up outperformance improvements. All in all, 49% of large cap managers beat the S&P 500. This may not sound great, until you compare it to the just 15% outperformance rate realized in 2021.

The outperformance of active fixed income also expanded in the difficult year. Just under 94% of all core-plus bond funds beat their benchmarks, while 79% of all investment-grade bond funds did so as well.

All in all, active managers had one of the best years in recent memory with regard to actually doing better than their benchmarks.

So why did active do better? For one thing, it comes down to one of Bogle’s original criticisms. And that’s costs. Just as ETFs brought down the fees associated with indexing to rock-bottom levels, they are doing so with active management.

Thanks to new active ETF fund launches and mutual fund-to-ETF-conversions, fees for owning achievement have started to come down in a big way. The average expense ratio for active ETFs now sits at around 0.44%. That’s dirt cheap when compared to the 1.5%+ rates investors used to pay for active management in mutual funds a few years ago. With a lower fee hurdle, managers can make the most out of a half or one basis point beat over an index.

Second, the beauty of active management is the ability to not look like an index. With stocks crashing, index investors were forced to take those losses. However, active managers were able to flee to cash and avoid losses or not hold problematic stocks in the first place.

The combination of the two allowed both stock and bond managers to beat their respective benchmarks for the first time in a long time.

Given their recent outperformance, the question is whether or not active can keep up the performance. The answer could be a resounding yes. For one thing, fees and costs for active ETFs have continued to drop. This will only make it easier for active managers to clear the lower fee hurdle.

Perhaps more importantly, the continued volatility and economic uncertainty make for a good environment for stock picking. Investors can focus on value, dividend payers, and other factors to pick up additional returns. At the same time, fund managers can use volatility to sell positions quickly to book profits. And one can’t forget that cash is now yielding north of 4%. The ability of managers to flee to cash and short-term securities can be a godsend during downward-trending markets.

With that, investors may want to consider getting active this year. While completely abandoning all their index funds may not be a good idea, boosting a portfolio’s share of some active muscle could be a great play, particularly in those areas that have had great outperformance. This includes small-cap and mid-cap space as well as in fixed income. The choices for ETFs in these spaces are vast.

In the end, active has won a very decisive battle amid a difficult market environment. Going forward, the current market malaise could yield similar results. Investors shouldn’t be so quick to cast aside active investing.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.