The Cyclical Nature Of Active & Passive Investing
2022InsightThe Cyclical Nature of Active & Passive InvestingRecent performance has favored passive investing. But a look at the big picture shows howperformance moves in cycles and reveals why active management isn’t dead.Reporters often prepare obituaries in advance for ailing celebritiesso that when the end comes, they can publish instantaneously.Occasionally, someone hits “publish” prematurely, posting tributesfor public figures who are very much alive.In the same way, much ink has been hastily spilled recently inobituaries for active management. Most of the negativity hasfocused on the rise of passive investing, which has enjoyed strongperformance during the past few years. But simply because one styleof investing has come into favor does not mean others are going theway of the dodo.So why are so many pundits ready to write off active management?And what makes us so sure that investing actively is not only a viablebut essential part of investor portfolios?1Key PointsThe performance of active andpassive management has beencyclical, with each style tradingperiods of outperformance.Market corrections are a regularand unavoidable part of marketcycles.Active management hastypically outperformed passivemanagement during marketcorrections, because activemanagers have captured moreupside as the market recovers.
InsightWhat Have You Done For Me Lately?FIGURE 1Recency bias is the tendency to believe that recently observed patternswill continue into the future, and it’s a powerful force that can influenceinvestor decisions. But investors who only take recent performance intoaccount are missing the forest for the trees. After all, yesterday’s eventsshouldn’t determine how tomorrow’s investment decisions are made.n WinnerMorningstar Large Blend is the largest Morningstar category with 6.37trillion in net assets, and it constitutes 23% of the US mutual fund market.1We selected this category because it’s widely believed to be the mostefficient—the one in which active investing supposedly makes the leastsense.To represent active management, we removed all index funds and enhancedindex funds. To represent passive management, we used the MorningstarS&P 500 Tracking category.As shown in FIGURE 1, passive large-blend strategies have outperformedactive large-blend strategies for the last eight years, which helps to explainwhy in 2021 passive US equity funds had inflows of 346 billion, while morethan 195 billion under active management headed for the exits.1But the past seven years only tell part of the story. A wider look at thechart reveals active and passive have traded the lead in performanceover time like two evenly matched racehorses. From 2000 to 2009, activeoutperformed passive nine out of 10 times. During the 1990s, passiveoutperformed active six out of 10 times. And over the course of the past35 years, active outperformed 14 times while passive outperformed 19times (they tied in 2010).We’ve seen that the cyclical nature of active vs. passive investing definitelyapplies to the Morningstar Large Blend Category. The same holds truefor other investment categories such as mid-caps, small-caps, and global/international equities. And just like performance, investor sentimentmoves in cycles. If a certain style or asset class is doing well, investorsare quick to extol its virtues and pour their money into it. It’s no surprise,then, that passive investing is the new darling of many investors andmuch of the financial press. But just as a marathon isn’t decided by thefinal 100 yards alone, we believe the dismissal of active managementbased on recent performance alone could be imprudent.No Clear Winner in Active vs. PassiveLarge-Cap FundsActiveLarge BlendCategory (%)S&P 500Index Funds 89.2411.92-1.0333.2420.9929.6620.6821.68- 0. 36- 8.05-19.8629.5111.576.7214.687.76-36.2929.1014.41- 0.3615.3932 .4911.07- 6.9022 .4 632 .7428.1820.34-9.4 4-12.11-22.3127.5710.424.4 1.4 821. 322018- 6.51- 4.80201929.0530.94202016.0218.52202125.6228.18Past performance does not guarantee futureresults. Indices are unmanaged and not available fordirect investment. Data Sources: Morningstar andHartford Funds, 2/22.* Active Large Blend is made up of funds from theMorningstar Large Blend category that are not index orenhanced index funds.* S&P 500 Index Funds are represented by theMorningstar S&P 500 Tracking category.1 Data Source: Morningstar Direct, 2/22.2
InsightActive or Passive? Yes.Like the ocean tides, active and passive management’sperformance ebbs and flows. And as FIGURE 2demonstrates, their performance cycles are clearlydefined. The chart compares the rolling monthly 3-yearperformance percentile rankings for active managerswith that of passive managers ranked within theMorningstar Large Blend category.Active Share: The True Measure for Active ManagersWhen it comes to active and passive, the debate isn’t assimple as an either/or choice. Many so-called active fundsclosely mirror the indices that serve as their benchmarks.These “closet indexers” offer no real value to active investors,and instead aim to slightly outperform the index by includinga few different names. The problem, of course, is that thismodest objective may not offer a real upside to justify thefees associated with active management.Investors who are looking for a true active managershould examine the fund’s active share, or measure of thepercentage of equity holdings in a manager’s portfolio thatdiffer from the benchmark index. By examining active share,investors can get a clearer picture of how an active manageris adding value, instead of relying upon returns alone. It’s acritical metric when trying to determine which funds are trulyactive or passive.FIGURE 2 shows that while overall there is no clearwinner over the past 30 years, there has been aclear winner in active vs. passive performance formultiple and sustained periods, followed by a tradingof positions. Once again the recent outperformanceof passive is evident, and is preceded by 11 years ofdominance by active management, and so on.The story that FIGURES 1 and 2 tell is clear. Just whenit seems that active or passive has permanently pulledahead, markets change, performance trends reverse,and the futility inherent in declaring a “winner” in activevs. passive is revealed anew.The Active-Share SpectrumINDEX0%CLOSET INDEXER20%40%ACTIVE60%80%100%CTGUT - Same data as below for WP287FIGURE 2Active and Passive Outperformance Trends Are CyclicalRolling Monthly 3-Year Periods (1987–2021)010-2040-3050Actively Managed Large BlendPassively Managed Large 89-4019886005,0000.26ActiPas-80Data Sources: Morningstar and Hartford Funds, 2/22.3-15.21 -14.94-10301987Morningstar Percentile Rankings– Large Blend Category020-5
InsightHome Runs: Part of the CycleActive/passive cyclicality is further demonstrated with highand low amounts of stock “home runs”—that is, a stock thatoutperforms the benchmark by 25% or more. Markets thatfeature large amounts of home runs signal dispersion in stockreturns. High dispersion should benefit active managers whocan single out the winners, whereas a low number of homeruns indicates stocks are moving together, which typicallybenefits passive management.In FIGURE 3, we’ve ranked the past 35 years from highestto lowest in terms of which stocks within the S&P 500 Indexhad the most home runs. The average number of homeruns during this time period was 217. Sure enough, in yearsthat feature a high number of home runs, active tended tooutperform. And when there were fewer standouts, passivewas the clear winner. It’s just another example of howthe performance of active and passive management hasremained faithful to cyclical trends.FIGURE 3Active Managers Have Generally Outperformed in High Dispersion MarketsS&P 500 Index (1987–2021) n Active OutperformsHome Runs% of HR% Active 3122722652%50%50%48%47%45%46%45%4 4%45%55%61%4 36%35%32%34%55%48%54%50%4 15515113512511430%30%26%25%22%26%35%4 4%22%19%Data Sources: Factset, Morningstar, and Hartford Funds, 2/22.4
InsightActive, Passive, and Market CyclesAt the individual sector valuation level, the S&P 500 Index0has a 20-year average price/earnings ratio (the ratio ofa stock’s price-10to its earnings per share) of 16.2. As ofDecember 31, 2021, the price/earnings ratio was 22.8.-20FIGURE 5 illustrates that 9 out of 11 sectors in the S&P 500-30Index are tradingat a premium relative to their 20-year0.26historical average. Active managers have the flexibility to-40consider valuations when choosing stocks, while passiveinvestments -50can’t use valuations as a consideration.FIGURE 4Equity Prices Have Generally Risen the Past DecadeS&P 500 Index Price Only (2000–2021)-60While bull marketscan last quite some time, they’re notActive Strategy Averageimmune to occasionalcorrections (as measured by a loss-70PassivekeepStrategy themAverage healthy. Like speedof 10% or greater) to help-80limits on highways,market corrections are a necessary evilin investing, but not one to be feared. They keep marketsfrom becoming overinflated and prevent valuations fromreaching heights that lead to damaging crashes. They canalso provide opportunitiesfor active 1998199719961995199419931992-55,0004,500Index Level (Price 1,000-35Market 91Despite a 33-day bear market caused by the COVID-19pandemic in early 2020, equities have generally risen formore than a decade (FIGURE 4). 2 Not only that, the value ofly Managed LargeBlendLarge BlendtheS&P 500PassivelyIndexManagedhas grownmore than 605% since its lowin March 2009. 32019-15.21 -14.94So what does cyclicality in active and passive managementperformance mean for you as an investor? We believe itdemonstrates the importance of maintaining perspectiveand minimizing the undue influence of fickle marketsentiment as you navigate changing market cycles. Insteadof letting recent performance enchant you into chasingreturns, you should instead consider current marketconditions and what the future could hold.Data Sources: Morningstar and Hartford Funds, 2/22.0.26Active Strategy AverageFIGURE 5Passive Strategy Average1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Nearly All Sectors Are Above Their Historical AveragesS&P 500 Sectors20 Yr Avg P/ECommunication Ser vices13.4% Change10.2-24%63%Consumer Discretionar y17.829.0Consumer Staples18.423.025%Energ 313%Industrials16.422.839%Information Technolog y19.128.348%Materials17.417.50%Real 41%Current P/E ratio is as of 12/31/21. Data Source: FactSet, 2/22.2 Data Sources: Ned Davis Research and Hartford Funds, 2/22.3 Data Sources: Morningstar and Hartford Funds, 2/22.512 /31/21-14.94-15.21
InsightActive Management Has Fared Better DuringCorrectionsThe most recent market correction arrived in February 2020.When corrections occur, you may not want to be exclusivelyinvested in passive. Instead, you may want to considerinvesting in actively managed funds.There have been 27 market corrections over the last 34years. FIGURE 6 shows that during those corrections, activeoutperformed passive 19 times, with an average rate ofoutperformance of 1.68%.4 Again, we compared active topassive by removing index and enhanced index funds fromthe Morningstar Large Blend Category to represent active,and used the S&P 500 Tracking Index category to representpassive.By allowing investors to respond to ever-changing markets,active management empowers investors to maximizeopportunity as conditions demand. But if you’re invested inan index fund, you could be exposed to significant downsidedue to single-sector performance. For example, during thecollapse of the dot-com bubble in 2000, active managementoutperformed passive significantly, -0.30% to -9.50%.5 Muchof the blame for passive’s underperformance during thatperiod can be laid at the feet of a single sector.As FIGURE 7 shows, the technology sector made up 28% ofthe S&P 500 Index at that time. The sector (as representedby the S&P 500 Information Technology Index) crashed hard,to the tune of a 38.72% decline in 2000.Meanwhile, the average active manager was underweighttechnology relative to the index (24% vs. 29%), which helpedlimit the damage done to their portfolios when the techbubble burst. Active managers with a positive return duringthis time were more underweight to technology with a 14%average weighting, and those with a negative return hewedcloser to the index with a 29% average weighting.6 Likewise,in 2014 when oil prices dropped significantly, passiveinvestors were hurt by their inability to reduce exposure toan underperforming sector.When bull markets inevitably turn, passive managers couldbe left holding stocks and sectors with poor fundamentalsand inflated valuations. Meanwhile, active managers havethe ability to help mitigate risk by reducing exposures toexpensive areas that will be hit hardest, and conversely,increase exposure as sectors or asset classes recover tocapture upside as the new market cycle begins.FIGURE 6Active Management Has Taken Corrections in StrideDate08/26/1987 10/19/198710/22/1987 10/26/198711/03/1987 12/04/198710/10/1989 01/30/199007/17/1990 10/11/199010/08/1997 10/27/199707/18/1998 08/31/199809/24/1998 10/08/199807/17/1999 10/15/199903/25/2000 04/14/200009/02/2000 04/04/200105/22/2001 09/21/200101/05/2002 07/23/200208/23/2002 10/09/200211/28/2002 03/11/200310/10/2007 03/10/200805/20/2008 10/10/200810/14/2008 10/27/200811/05/2008 11/20/200801/07/2009 03/09/200904/24/2010 07/02/201004/30/2011 10/03/201105/22/2015 08/25/201511/04/2015 02/11/201601/27/2018 02/08/201809/21/2018 12/31/201802/20/2020 03/23/2020ActiveManagementLarge Blend12 /31/21S&P 500Tracking12 /31/21Dif ference-15.84-22.276.43-13.64-16.642 .99-9.79-12.082 9.89-19.12- 0.77-10.89-9.77-1.12-11.36-11.840.4 8-10.63-10.910.28-20.31-26.886.57-24.33-25.781.4 4-28.18-31.142 0-36.27-36.14- 0.13-15.80-15.16- 10-20.19-18.59-1.60-11.57-11.880. 31-13.61-12.74- 0.87-9.75-9.990.24-14.21-14.05- 0.16-34.12-33.51- 0.61Average Outper formanceActive winsPassive Wins4 Data Source: Ned Davis Research, 2/22.5 As represented by the S&P 500 Index, from 1/1/00 to 12/31/00.6 Data Source: Morningstar, 2/22.61.68198Data Sources: FactSet, Morningstar, and Hartford Funds, 2/22.
InsightFIGURE 7Index Funds: Individual Sectors Can Have Outsized Impact1/1/2000–12/31/2000 S&P 500 Index SectorsSector% Average Weight% Total Return% Impact on PerformanceCommunication Ser vices6.75-38.82-3.02Consumer Discretionar y9.78-23.61-2.63Consumer Staples8.655.350.45Energ .6638.353.64IndustrialsInformation Technolog y8.843.240.1528.34-38.72-11.35Materials2.00-16.41- 0.38Real Estate0.10-26.65- 0.03Utilities1.9853.590.80Total100Data Source: FactSet, 2/22.Investment Implications:This insight focused on active vs. passive investing in theMorningstar Large Blend category because it’s widelybelieved to be the most efficient category—the one thatshould invariably favor passive investing. Yet even thiscategory shows the cyclical nature of active and passiveperformance. The same cyclicality is present in otherinvestment categories such as mid-caps, small-caps, andglobal/international equities.Just as we think declaring active management dead ispremature, we don’t contend that active management is theonly suitable choice for investors. Far from it. We believethat the choice between active and passive management isnot a zero-sum game, but that each has a place in investorportfolios based on the individual needs and wants of theinvestor. With that in mind, here are some conclusions totake away from this piece:The performance of active and passive managementhas been cyclical—each style has experienced extendedperiods of outperformance.When evaluating active and passive management, lookingbeyond recent performance and measuring active shareis important.As we saw in February 2020, market corrections areinevitable and a common occurrence in equity marketsover time.There have been 27 market corrections over the past35 years, and active management outperformed passivemanagement in 19 out of 27 corrections.During market corrections, the flexibility of activemanagement allows for reducing exposure on thedownside and ramping up exposure to capture alpha7in the early stages of recovery.Talk to your financial professional about the benefits ofincorporating active management into your portfolio.7 The measure of the performance of a portfolio after adjusting for risk. Alphareliable but the accuracy and completeness of the information cannot beguaranteed. This material and/or its contents are current at the time of writingand are subject to change without notice.This information should not be considered investment advice or arecommendation to buy/sell any security. In addition, it does not take intoaccount the specific investment objectives, tax and financial condition of anyspecific person. This information has been prepared from sources believedInvesting involves risk, including the possible loss of principal.is calculated by comparing the volatility of the portfolio to some benchmark.The alpha is the excess return of the portfolio over the benchmark.hartfordfunds.com888-843-7824Hartford Funds Distributors, LLC, Member FINRA.WP287 0322 227968hartfordfunds.com/linkedin
then, that passive investing is the new darling of many investors and much of the financial press. But just as a marathon isn't decided by the final 100 yards alone, we believe the dismissal of active management based on recent performance alone could be imprudent. FIGURE 1 No Clear Winner in Active vs. Passive Large-Cap Funds
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Le genou de Lucy. Odile Jacob. 1999. Coppens Y. Pré-textes. L’homme préhistorique en morceaux. Eds Odile Jacob. 2011. Costentin J., Delaveau P. Café, thé, chocolat, les bons effets sur le cerveau et pour le corps. Editions Odile Jacob. 2010. 3 Crawford M., Marsh D. The driving force : food in human evolution and the future.
