Active vs. Passive Management

According to FactSet, the start of 2017 has been the best year for earnings growth rate since the end of 2011.  To date, the number of companies beating their sales and earnings estimates is above the 5-year average. As long as earnings growth rates remain in double-digits, markets should continue to climb.

The major trend emerging this year is that money is flowing into overseas markets. With political uncertainty playing out in Washington, investors are reallocating into Europe and Emerging markets. This week, Jeffrey Gundlach, who is Chief Executive Officer and Chief Investment Officer of DoubleLine Capital, took this trade one step further. He recommended to short the U.S. stock market and buy Emerging Markets. This is called a pair trade. As long as Emerging Markets outperform the U.S stock market, he will make money. He is not extremely bearish on the U.S markets. Rather, he favors Emerging Markets much more than the S&P 500.

Last year, Gundlach surprised markets when he predicted that Donald Trump would win the U.S. presidency. He was also correct with in is prediction when he called the bottom in interest rates. This new forecast is that too many investors are piling into passively managed funds. He believes that these investors are blindly making investments that they don’t fully understand. This also has been a very concerning trend for me.

There has been a backlash against active managers over the past 12 months. Ned Davis, who founded an investment research group that is now one of the largest independent institutional investment research providers in the market, recently wrote, “Don’t worry about fundamentals, or values; don’t worry about market timing; just buy the market and hold! Even if there is a small correction, the market has always come back! Sounds ‘bubbly’ to me.”

I strongly believe in both an active and passive approach to selecting investments for my clients. There are some investments where an active manager can add value and are worth paying a higher expense. For instance, I would never invest in an High Yield exchange-traded fund. I am very comfortable paying for an analyst to review the credit risk of the company and that company’s ability to pay. It is important to understand bond covenants and actual recovery rates if that company does get into financial difficulty. If you invest in the High Yield ETF, you are investing in a basket of companies that have the most debt and you have no idea if management has the willingness or even the ability to pay you. While this is an extreme example, it can be applied to other sectors of the market.

I believe that this trend towards passive investing will continue and even accelerate in the next few years. There was a technology bubble, a housing bubble, and at some point we are going to have to navigate through the coming passive ETF bubble.

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