ETF Edge - Active vs. Passive Management – Who’s Winning in 2022? 9/26/22

Episode Date: September 26, 2022

CNBC’s Bob Pisani spoke with Tom Lydon, Vice Chairman at Vetta-Fi, and Anu Ganti, Senior Director of Index Investment Strategy at S&P Dow Jones Indices. They delved into the age-old debate of active versus passive management. With market volatility on the rise, many active fund managers claim this is their time to shine – and according to the latest SPIVA survey out from S&P Dow Jones Indices, actively managed funds are enjoying their best performance against their benchmarks in over a decade. But is all that enough to beat out passive investing in the long run? In the Markets ‘102’ portion of the podcast, Bob continues the conversation with Tom Lydon. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange-traded funds, you're in the right place. Every week, we're bringing you interviews, market analysis, breaking down what it all means for investors. I'm your host, Bob Pisani. With market volatility on the rise, many active fund managers claim this is their time to shine. Really?

Today on the show, we'll delve into the age-old debate of active versus passive management. According to the latest S&P SPIVA survey out from S&P Dow Jones Indices, actively managed funds are enjoying their best performance against their benchmarks in over a decade. But is all that enough to beat out passive investing for the year? We'll discuss that. Here's my conversation with Tom Light and Vice Chairman at VETI, along with Anu Ganthi. She's the senior director of Index Investment Strategy at S&P Dow Jones Indices.

I know 51% of large cap fund managers underperform their benchmark in the first half of this year. I know that sounds terrible, right? 51% underperform. That doesn't sound very good, but it's the best performance since 2009. On average, 68% of large cap managers underperform. It's going back 10 years. I'm averaging out. So what are active managers doing right and we're doing better this year? You're right. 51% underperformed year to date. Now, if we go over 20 years, 95% percent. underperformed. So let's remember that historically underperforming, you know, beating the benchmark is very tough. And there's a few key reasons why we saw this tailwind in the in the first half of the market. It's a declining market. We saw losses across equities. We saw losses across fixed income,

macro risks, including rising rates and rising inflation. And in this environment, active management skill can potentially be more valuable for a few key reasons. Number one is rising dispersion, which measures the spread among returns and an index. And the greater that dispersion is, the greater the opportunity to add value from stock selection. It also magnifies the risk of picking a laggard. So there were plenty of opportunities for value to add value and plenty of opportunities for embarrassment as well,

which was reflected in the results. And by the way, the dispersion that we saw is on track for its highest reading since 2009, which you mentioned is the last time we saw this relatively lower-level. level of underperformance. And two other points for you. One is the underperformance of mega-caps that we saw. So historically, we've seen that active portfolios tend to be closer to equal than cap-weighted, as it's tougher to overweight those big mega-cap names. So perhaps that was another tailwind, the underperformance of mega-caps. And finally, we've seen value, the recovery and value after

decades of underperformance. So these are all some of the reversals this year that potentially played a role in determining that number. Tom, I wonder what your thoughts are about this. You've been following is active versus passive debate like me for decades. What strikes me is just in the ETF business, actively managed ETFs continue to come out, even though long-term performance is poor. Nobody seems to be giving up on the point. So it is good news for the ETF space. Again, as you said, a lot of new managers coming in. You've got Capital Group. You've got Morgan Stanley, New Burger Berman, Matthews, Asia that are all bringing some of their best strategies to ETFs. We hope that we're going to see less fees.

We think we're going to see a lot more tax efficiency. Trading costs have come down, which are all things that work against you trying to beat that benchmark. It's really tough to beat the S&P 500, especially when the market's doing well. However, this last year, you think that more managers would have outperformed. I mean, you look at areas like energy and utilities that collectively only make up 8% of the weight in the S&P 500. I think they would have pushed a little bit more in in some of those tech sectors where it's, you know, communication services or what do you call them the techies? So it's interesting that you bring up sectors, you know, if I can add, you know, I was talking about dispersion earlier.

So we saw widespread among sectors. If you look at the spread between energies outperformance versus the underperformance and technology and communication services. So there was greater value for being a sector allocator if you think about rotating tactically among sectors and not necessarily from the individual stock call. So it's very interesting to think about sectors in this environment. Yeah, but as Tom said, you know, it's nice to be, you know, right once in a blue moon on owning energy stocks. Energy was what? In 1990, 30% of the S&P, now it's 4% of the S&P. Eventually, you're right. Up from 2.5.

Good luck. You're now finally right, 30 years later, if you're in energy. But if you were reading the tea leaves and just getting the signals from economists in the markets, you think you would have pushed a little bit more in. And to your point on individual stocks, coming out of the financial crisis, it was the fang stocks that really got us that extended growth. We haven't been talking a lot about stocks this year. It's all about defense. But I think there's too much sector hugging, which is impeding the ability of advisors and managers to

beat their benchmarks. Yeah. I just want to point out everybody still, despite this relatively good start, the S&P has been doing this annual study of active managers for more than 20 years, and the long results are abysmal. Regardless what has happened so far this year, look at these numbers. After five years, and this is on his report here, 84% of large-cap active managers underperform. After 10 years, look at these numbers. 90%. After 20 years, as Anu said, 95% of active fund managers underperform. What is amazing, Anu, is that this underperformance really goes across almost all categories. In this case, I'm talking about large-cap funds, but the underperformance really is astonishing across small-cap, you know, mid-cap.

And I'll give you an interesting example. If we look at growth managers, it was a disappointing year-to-date for large, mid-and-small-caps across the board. And it's interesting because initially you would have thought that perhaps they could have tilted towards value, which outperformed. But the data really shows that that wasn't really the case. And perhaps these growth managers were more concentrated in the growthier names compared to our index. And hence they were hurt by that weakness in growth. Yeah. I just have to get to the core of this issue because I've been thinking about this for 20 years.

And people who are smarter thinkers than I am, like Burton Malkiel and Charlie Ellis, who've written, textbooks on this, I have studied this. I guess the question, folks, you should be asking when you see this, is what accounts for this? Astounding underperformance. 90% underperforming after 10 years. Think about this. Now, the S&P in a 2019 study had this to say, the persistence of fun performance was worse than would be expected from luck. Worse than would be, in other words, that's the whole dartboard thing, remember, Tom? We were throwing out. Worse than would be expected from luck. One of the key points of your study is you account for both fees and what you call survivorship bias. Before I will get to that, explain why we're getting this

underperformance here. You mentioned this many times. Managers take a look at the sport here. Managers competing against each other. Managers trade too much. The costs are too high. Address some of these issues. Absolutely. And number one, I'd like to point out is costs, right? we've seen historically that active managers generally have higher costs than that a passive. So right off the bat, they're starting off with a higher hurdle, a higher benchmark to beat. And second is a concept that we've studied extensively called skewness. So if you think about a bell curve, stock returns are not normally distributed, right? Stock can go down by 100%, but it can appreciate by much more.

And we've seen that most equity markets are dominated by a few winners, And that can hinder more concentrated active portfolios, as we've seen in the past. And finally, let's look at the professionalization of the industry. If you look at the 1960s and then the 1970s and compare it to now, the industry has become more dominated by professional institutional investors. And they're competing against each other. And it's making it that much harder to generate that alpha. So these are some of the things to think about from why it's been so hard.

This is one of the things Charlie Ellis talked about in winning the losers game, about the difficulty of active managers. It's not because they're stupid. It's actually because they're getting better and better. But in the 1960s, Tom, the market was dominated by the retail investors. If you were an active manager, you might have had an information edge. Today, you're competing primarily against professional managers. So professionals against other professionals with very little informational advantage.

That makes out performance difficult. And against the indexes, right? So also against the indexes. But the big question is, how can so many managers still have, have poor performance and still garner assets. You know, I think there are a couple of things. When we talk about fees, that can work against performance, but it sure helps by putting feet on the ground

and putting up a bunch of ads all over the place where you may not see that as much in ETFs. Number one, and that's really important. The other thing is our age-old problem about not getting enough ETFs in 401K plans. We still have a lot of active managers in there. They still stuff with large fees. 75% on every dollar of new money going into Fidelity funds goes in via 401K plans.

I think eventually it's going to chip away. We've got over $400 billion in new assets coming into ETFs this year, $120 billion coming out of mutual funds. It's going to take a while before those lines cross. Jack Bogle, a man who had a tremendous influence on me as the founder of Vanguard, was a big believer, of course, in indexing. He helped found one of the very first index funds. And yet he was also involved in creating active management at Vanguard. He invented Capital Opportunities Phone, which still actively managed. And his mantra was generally people are better off in index funds, but if you want to try active management, the key thing is keep the cost low.

And that's what you were going, the point you're going to. Unfortunately, the 401k business is still dominated by people who make money. And low-cost ETFs aren't going to make that much money. It's really that simple, isn't that the problem? It is. And there's one other thing, just to slide in here. We're going to have one of those years where equity markets may be down, fixed income markets may be down, and active managers may have to go into low cost basis stock to sell them to meet redemptions, which is going to create what? More so year-end capital gains distributions. So you don't want in a year where you've been the one to hang out, get a year-end present that's unexpected and unwanted. Yeah. I want to go back to one of the things that your study does that's very important, which is you keep everybody honest. Not only does S&P look at the actual cost, what are they actually charging, and how does that detract from the overall fees, but you have been very particular about studying what you call survivorship bias.

Now, tell us what is survivorship bias and why is it important in determining return? I'm so glad you brought that up because that's a very important point. And you're right. Our SPIVA report, it stands for S&P indices versus active. We've been producing this for 20 years. And there's a few key metrics that you hit on. Number one is survivorship, right, where we account for the entire opportunity set. And not just the survivors.

So that way we're eliminating that survivorship bias from, say, funds that have been merged or liquidated. Well, I want to get this clear because I think you're making a very good point. The industry tends to eliminate the funds that are losers, right? So if you have a fund, and it's only around three or four years, and you're in the fund, and it goes away, it doesn't show up in indexes where people account for that. And even though you might be the guy in it, you lost the money. It won't show up. So you're saying survivorship bias can skew the results, right?

Yeah. Well, we think it's important to look at the entire opportunity set, so that way you're eliminating that bias from funds that have been liquidated or merged. And two other points to add, we mainly look at the percentage of funds that have outperformed their benchmark. And we also look at asset and equal weighted averages. So these are some of the key metrics. And by the way, we do this not just in the U.S., but we do this all across the world, and we see similar results globally. So the important thing here is a lot of funds don't survive 10 years, right?

I mean, that's a really key point. Most funds are, a lot of them are just bad. They just don't do well, and they close them. And that's something people don't think about when they think about these studies. These funds that close because they're terrible don't get often cited or mixed in with broader results. And you actually account for that. I think that's very, very important. Right.

We account for that. And we also look at an apples to apples comparison versus the appropriate benchmark. And we think that's so important to measuring this. And we also look at it over various time horizons like you brought up earlier. So one year, three year, five year, 10 year, all the way to 20 years, we look at the performance results over the various time horizons. And as I mentioned, the underperformance rates generally tend to increase as you broaden out the time horizon. Yeah. I know this is a little intellectual, but this is absolutely key to understanding long-term investing. So I want to get even higher level here and get Tom and Anu's opinion on this.

One of the key findings of people who look at forecasting long term is, first of all, how bad forecasting results are in general. Everybody's bad at it, not just stock pickers, but economists. The Federal Reserve is a terrible track record. And other forecasters in areas outside of economics have generally very bad forecasting records. So what is it? Why is the future really very difficult to figure out?

It is, in fact, unknowable to some extent. Why is this? What is the problem with forecasting the future accurately? And, you know, Anu and Tom, I've been very influenced by a fellow named Philip Tetlock who wrote a great book called Super Forecasters, where he looked at forecasting in general, made the same conclusions I did, and determined there were a couple of real big problems. And I'm going to respond to this. One is that forecasters have a lot of biases that influence and skew their own results.

They may have overconfidence. They may be too concentrated in one area. They may have a limited worldview. They don't have enough data. The other is that it turns out, try being a stock picker, try being an analyst who's looking at fundamentals and is trying to predict where a stock is going to be one year from now based on what he thinks the earnings are going to be in December. It turns out that there are millions of variables that actually influence a stock price.

And it's almost impossible to get all those variables right. It's like forecasting the weather three months out. almost. So these seem to be real fundamental problems, bias, and the fact that the data set isn't really big enough to actually understand because you don't know what could happen, all the millions of variables. Doesn't that make you a little more humble when you're trying to make, I mean, I've become much more tolerant of stock forecasters knowing that it's essentially an impossible job. And the numbers bear that out, that 90% underperformance. You're absolutely right that predicting the future is tough.

You don't know what's going to happen in the future. Tom doesn't know what's going to happen. I don't know what's going to happen. And going back to the point I made earlier about skewness, that's why we really at S&P believe in the benefits of an indexing approach, because by owning more stocks, you have the benefit of diversification and luck on your side. Because today, you might not know what the winners are going to be tomorrow or next year in the next five years. So broadening out and having that index approach and owning more stocks gives you the tailwind of positive skewness so you're exposed to those winners.

So absolutely. We were Tom talking about the growth managers. She's right. The growth managers have did really terribly this. And active managers did all right. But look at these numbers here for growth managers. 79% of large-cap active managers who were in. This is for the growth space.

okay, growth. This is technology, essentially, underperformed, even mid-cap, 84%, small-cap, 89. This is much worse than the general big-cap fund managers. Any thoughts on why this happened? I mean, here, this is a year when, obviously, growth dramatically underperformed. Well, all you had to do is have some high conviction and play a little bit of defense, you know, push more to cash, push some in utilities or energy. But Bob, back to you. to your point about trying to predict the future and the fact that the vast majority of managers underperform over the long term. We just were at a great conference in Southern California. The average age of the advisor was 35. They have one thing you and I don't have, which is time.

One thing that we could tell them would be, look, get your ego out of it. Don't try to predict. Don't try to be a stock jockey. There's some great benchmarks out there. And again, plain vanilla S&P 500 over time does really, really well. And I think we always look back at periods like this where we've the market's challenge, we've seen some market pullback, use these time if you've got a long-term outlook to work for you. And don't think about who's the best manager today because it's a long-term game, right? Yeah, well, and we were at the Future Proof Conference, Josh Brown's conference last week, you and I, and it was a wonderful conference, and I did a lot of interviews.

there, but what takeaway do you, does SEP have? I mean, I know you're a big believer in indexing. Yeah. Yeah. Yeah. I have to own the biggest index. That always helps. This is standard of pores we're talking to. Right here. That's helpful. But what other broad advice does, just looking at these numbers objectively, what broadly can you conclude? I think the key takeaway that we've seen is beating the benchmark is tough. And it's especially, it's gotten tougher. The longer you go out on the time horizon. And you talked about growth earlier, right? 79% of large-cap growth managers underperform year-to-date. Now, when we take it out to 20 years, 98% of them underperform. So that's a very powerful statistic to keep in mind as you broaden out

the time horizon. And if we go back to the key points of why it's been so challenging, we've talked about cost, we've talked about skewness, we've talked about the professionalization of the industry. And it'll be interesting to see how the industry evolves over the the coming years as we get exposure to different asset classes. But at S&P, we like to use a term called Indicize. And that means putting into passive form strategies that previously you could only access via an active manager. So say 30 years ago, if I wanted exposure to low volatility or quality, I had to go to an active manager. But now you have the index available. So indicizing has been very powerful over the past few decades. This is why I cover the ETF business and why he's here.

We all, it was very obvious to all of us 20 years ago that this was a business that was very powerful, provided low-cost alternatives, not just to big indexes, but as Ano said, now to what we call thematic ideas, like, of course, cybersecurity, for example, or pot stocks, or any kind of Bitcoin-related activity. And this is part of the great value that ETFs provide. It doesn't mean you're going to necessarily make any money. investing in cybersecurity stocks long term. But if you're doing it, you're certainly going to do it at a lower cost. And as Tom has said time and again, Jack Bogle said it is cost long term that really matter.

That's what eats into Alpha. There's Jack Bogle's central insight. This has been an interesting discussion, folks. I hope you took it to heart. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETS. This is the market's 102 portion of the podcast. Today will be continuing the conversation with Tom Lighten from VETI. Tom, we had a great discussion with Anu about active versus passive investing,

active investing doing a little bit better this year than they had in prior years, but still pretty abysmal. It was. Key fact here, folks, 90% of large-cap active fund managers underperform after 10 years, 90%. And yet I want to ask you about bond funds. We keep seeing this chaos in the bond market. You follow ETF flows very carefully. are people fleeing bond ETFs?

What's the trend right now? Well, they were, Bob. You know, we're watching the asset flows very, very carefully. And fixed income ETFs actually had net redemptions in the first four months. It wasn't until May kind of triggered by the Fed being honest and transparent about their future moves about rising interest rates. At that point in time, a lot of investors and investors, advisors took it to heart and said, okay, I have an opportunity to buy at lower levels. Yields obviously are more attractive. If I can go short duration, if I can use active managers

who tend to be pretty good during these periods of time, then money started to flow in. And in fact, a follow-up to our conversation with Anu was the best-performing managers that outperform the benchmark were core bonds. 93% of core bond managers outperformed in the first half of 2022, which is historically great. So we're active equity managers didn't do that great. Fixed income managers did pretty well. I'm curious about why suddenly there's been inflows into bonds because you're buying prices, not yield, and the prices have still been going down. Is there a reason some people, what's the thinking here? Well, obviously everything's affected by rates and as rates continue to rise, the value of the underlying due decline. However, they could go in at these levels

and buy set durations from a short-term standpoint. So they're not as affected by the fluctuation in rates. It is by low, sell high. It's not by high. We tend to, you know, forget that simple fact overall. What else are you seeing in, you know, for those of you don't know, VETI, essentially provides training to investment advisors. So you got your finger on what they're looking for and what they want. What are RIAs? What are investment advisors? So we're looking at the number of times that they look at a specific article about a specific subject matter, about a specific ticker or types of ETFs, and we've seen this pendulum shift back into fixed income in the last three or four months. Some areas that have been really interesting have been set duration or

like bullet shares. You know, Vesco's got the bullet share ETFs. They've got a, U.S. Bullet share, high yield, it's got a 5.2 yield at this point. And again, remember, not as affected by rising rates because those swoop in by that bond that's going to mature at the end of 23, and you're pretty much safe to get that yield at that point in time. Also, I shares has a set duration, global bond, ETF, which can take advantage of some of the opportunities overseas where we know they're struggling a little bit more, their yields a little bit more rich. But if you go in and buy those set durations, and these opportunities are getting

five to five point five percent short duration, set maturity, not bad at these points. Yeah. Well, with a four yield at four percent plus, my mother called me the other day. My mother, my 94-year-old mother who watches CD rates, which are terrible, called and was noting, Robert, I see these CD rates. This is a bank seat. It's about the worst investment you can make. But you can buy a two-year at 4% plus. That's pretty amazing.

Well, think about all the money and money market funds. We're just a couple short years ago was paying a big goose egg. And now it's actually meaningful. It's nice to see some positive numbers in your portfolio, especially if you've kept your powder dry. Yeah, it's quite remarkable if you ask me. So I know you're not a, I know you're not a strategist. But how do you see things playing out for the rest of the year?

Can you put on your strategist hat? We are way, way overbought. I find it hard to believe that we, I mean, there are people calling for 3,200 on the S&P. That's another, you know, 400 or so points away. I guess that can happen. You know, now you're talking about, you know, instead of 20% down, you know, you're talking about 25, 26, 27, 28, you know, heading for 30%. down. What my historic experience tells me is that doesn't happen too often. Most of the time,

there's been 15 times the S&P has dropped more than 20% since 1926, but only seven of the 15 is it drop 30% or more. So most of these drops happen between 20 and 30%. Yeah. And historically, if you have a year like that, the next year is up 20% on average. You get your money. In more than half the time in those drops, you get your money back in a year. But it's tough. It doesn't feel good. We don't have that, you know, emotional fortitude to kind of stick it out. That's why advisors are doing a good job holding a lot of hands, stick into their disciplines, and we're seeing that in what they're allocating. So it's positive. Fingers cross, we get positive inflation numbers on Friday, which might stop the bleeding here. Yeah, that's the PCE, of course, the personal consumption

expenditure, which is the Fed's preferred gauge for inflation. Tom Leiden, thanks very much for joining us. Folks, Tom Lighten is the Vice Chairman of VETIify. Thank you for listening to the ETF Edge podcast. Investco QQQ believes new innovations create new opportunities. Become an agent of innovation. Investco QQQQQ, Invesco Distributors, Inc.