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 Since the advent of indexing as an investment strategy, there has been a robust debate over the merits of actively and passively managed funds. As a result, at various times throughout the year, an investor is likely to hear that some percentage of actively managed funds have outperformed the stock market over a given period of time.1 If during the period a majority of active managers have under-performed the market, the common opinion is that indexing is a superior strategy. If a majority of active managers have outperformed the market, we hear the reverse: that the way to add value going forward is through active investment management. But with leadership changes common, it's easy to see how an investor may be confused about whether indexing or active management is the better choice in seeking higher returns. And a natural follow-up question is: Why can leadership change so dramatically?
As is often the case with the financial markets, the answer is not a simple one. Of course, over long periods we would expect active management strategies to trail appropriate benchmarks by the margin of their expenses [Philips and Ambrosio, 2008]. However, over shorter and intermediate periods there are many factors that can lead to significant deviations between a strategy's returns and those of its benchmark. For example, if a manager intends to closely track the S&P 500 Index, but strategically holds 5 percent of her portfolio in cash, she is likely to under-perform in strong bull markets because of the cash drag, but outperform in bear markets. Depending on how long a market environment lasts, that manager may experience significant periods of relative outperformance or under-performance simply because of the cash allocation. Similarly, if a manager holds a portfolio of stocks with an aggregate market capitalization smaller than that of the benchmark, and if all else is equal, he will likely under-perform during periods in which the larger stocks outperform, and outperform during periods in which the smaller stocks outperform.
In this paper, we examine the active-versus-index debate from the perspective of market cyclicality, and provide context for the changing nature of performance leadership. We show that when evaluating the performance of active managers versus a given benchmark, investors should be acutely aware of the differences in the managers' strategies involving factors such as size (market capitalization), style (price/earnings ratio and price/book ratio) and relative positioning.2 Overall, we show that the market environment can have a greater impact on relative performance than manager skill or even cost differences. Most important, we show that during periods of significant performance deviation between opposing market segments (for example, large- and small-capitalization, or growth and value), there will be a wider distribution of returns among active managers, and more pronounced differences in how managers perform relative to the market. However, during a prolonged period of less-severe deviations, we would expect fund styles to have less of an impact, and costs to have a major influence on relative returns.
Setting The Stage: Is 10 Years Long Enough?
Today, a majority of investors would probably consider 10 years to be a long-term investment horizon. However, even over 10 years, historical trends don't always hold true. For example, although stocks have outperformed bonds and cash over the very long term, they have lagged bonds in 11 of 73 rolling 10-year periods since 1926, and even trailed cash nine times. The performance of active funds relative to a broad market benchmark can be similarly volatile. As Figure 1 demonstrates, in the 10 years ended December 31, 1999, 69 percent of active managers under-performed the U.S. stock market, represented by the Dow Jones Wilshire 5000 Index. But during the 10 years ended December 31, 2007, we see a dramatic shift in the distribution of returns—in this period, 41 percent of active managers under-performed the U.S. stock market, a change of 28 percentage points over eight years. While this volatility clearly implies that 10 years is not long enough to be considered "long term," it also raises the question of what exactly may be contributing to this shift in performance leadership.
Of course, one widely noted change from the 10-year period ended 1999 to the 10-year period ended 2007, was the nearly simultaneous shift in performance leadership from growth stocks to value stocks and from larger stocks to smaller stocks. As the large-cap-growth bull market of the late 1990s ended, small-cap stocks and value stocks began to outperform. Figure 2 demonstrates the magnitude of this shift. Focusing on the green line, representing the cumulative 10-year spread in performance between value stocks and growth stocks, we see from 2000 to 2007 a reversal in the trend established in the 1990s, when growth had dominated value. A similar shift is noticeable in the gray line representing the cumulative 10-year spread between large-cap stocks and small-cap stocks. By the end of 2007, value had outpaced growth over the previous 10 years by a cumulative 32 percent, and small-cap had outpaced large-cap by a cumulative 22 percent.
Such an extreme spread in performance between large-cap growth stocks and small-cap value stocks and the reversal in dominance between the two segments in 2000 are important for two main reasons. First, large-cap stocks typically account for close to 70 percent of the capitalization of the aggregate market, with mid-cap stocks making up approximately 20 percent and small-cap stocks 10 percent. So it is no surprise that the market will realize a total return more similar to that of the large-cap segment than to that of any other segment.
In an environment characterized by such a significant return spread between segments, as has been the case since the late 1990s, the performance of the large-cap segment will play an even greater role in the performance of the market, as well as the performance of fund managers. For example, in Figure 3, we show a hypothetical scenario in which large-cap value stocks outperform large-cap growth stocks by 500 basis points. Because of the distribution of weights across the six style boxes, the market itself outperforms every market segment except large-cap value. In such an environment, active managers in the large-cap value space would probably find it easier to outperform the market (since their style outperformed the market), while active managers in the remaining style boxes would face a headwind beyond their control—an environment in which their particular style is decidedly out of favor and lags the market.
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