Active management makes a comeback

Passive management, or index-tracking, became much more popular following the financial crisis. A high level of correlation between the various asset classes between 2008 and 2016 worked in favour of the passive investment approach. During that long post-recession recovery period, inflows of liquidity into the markets along with low bond yields, driven by ultra-loose monetary policies, encouraged large-scale buying by investors.

Yield-seeking investors pumped money fairly indiscriminately into segments deemed likely to deliver returns higher than the traditional risk-free rate. As a result, the main asset allocation decisions involved investing in riskier bonds and in equities. As indexes rebounded from their lows, equity investments took place mainly through index-tracking ETFs to the extent that global assets under management in ETFs rose from $750 billion in 2008 to almost $3,500 billion in 2016. The outperformance of the major indexes was self-sustaining, not because of the fundamentals but mainly as a result of money flowing into ETFs.

Market behaviour is returning to normal and decorrelation is making a comeback

Now, however, active management is set to see a resurgence among equity investors. Correlation between stocks is falling towards normal levels, since the recent increase in bond yields and monetary policy normalisation are causing investments to show widely varying behaviour and returns depending on the fundamentals. This means that stock selection is once again adding value, including within individual sectors, since it enables investors to take advantage of sector or style rotation.

As regards style, for example, a "value" stock automatically becomes more like a "growth" stock if its price rises, all other things being equal. As a result, to maintain a pure value strategy, an asset manager needs to take a fairly dynamic approach, refreshing the portfolio regularly by taking profits on holdings that have become growth stocks and reinvesting the proceeds in other stocks that are trading at an unjustified discount. Passive managers only make these kinds of returns-enhancing switches once per year, when the index they are tracking is reconstituted.

Positive momentum for US mid-caps: an argument in favour of active management

Finally, the new US economic policy landscape will also affect the way investors view markets. Tax-based stimulus, massive public-sector infrastructure investment and policies to boost domestic activity in the USA should primarily benefit small- and mid-caps, which have historically been more sensitive to domestic economic growth. Since 1926, the 10 phases of Fed rate hikes – synonymous with economic recoveries – have seen small-caps outperform blue chips. In the 12 months following Fed funds rate hikes, small-caps have returned 14.5% as opposed to 10.5% for large-caps.

And if there is any area in which active management is vital to achieve good returns, it is the small- and mid-cap segment. All of this means that active management is about to make a comeback.