Active funds find few takers despite performance uptick
US active managers have posted their best performance for years in 2017, according to Morningstar, though this hasn't stopped an increasing number of investors turning to passive alternatives. A drop in correlations between asset classes accounted for an upturn in active performance. Despite outflows from active equity funds, flows into bond offerings meant active products took in a net $25.5bn in 2017 to-date, where passive funds have seen almost $635bn in inflows. 

Passive investing won 2016. Not only did the vanilla style of investing broadly outperform its active counterparts last year, but it extended its domination as the strategy of choice, amassing billions of dollars in inflows while money flooded out of active funds.

This year, in contrast, the two are ending in something of a draw.

Passive funds were heavily favored over active, as investors continued to trend towards low-fee, broad-market products to take advantage of the ongoing global bull market, showing a particular preference for exchange-traded funds, which sit at the center of all these trends. However, the returns side of the equation was more nuanced, as active managers staged their best aggregate performance in years, helped by a long-awaited rise in stock dispersions.

According to data from Morningstar Direct, actively managed U.S. equity funds (including both ETFs and mutual funds) have seen $181 billion in outflows thus far this year. Passive stock funds have seen inflows of $199.6 billion over the same period. U.S. stock ETFs alone have seen year-to-date inflows of $308.6 billion (the smaller number for passive overall reflects an investor move from mutual funds into ETFs).

For all fund categories, passive products have seen $634.7 billion in inflows, compared with the $25.5 billion in net active inflows. Flows were positive for active funds due to the $171 billion that went into active taxable bond funds, a category of product where active is seen as offering more value. However, passive taxable bond funds had $193.7 billion in year-to-date inflows.

Related:Passive investments are hot, but remain a small slice of the stock market

In an actively managed fund, the components of a portfolio are chosen by an individual or team, whose aim is to outperform the broader market through individual security selection. This is in contrast to passive funds, which are designed to mimic the performance of an index like the S&P 500 SPX, +0.24% or the Russell 2000 RUT, +0.56% by holding the same components it does, and in the same proportion. Data have repeatedly shown that passive funds show better long-term performance than their active counterparts.

Over the shorter term, however, active funds can enjoy periods of broad outperformance, as occurred in 2017, despite the move out of even outperforming funds.

According to the latest “Active/Passive Barometer” from Morningstar, 10 of the 12 asset-class categories the firm tracks had more active managers outperform their underlying index this year compared with last year, while a majority outperformed in eight of the 12. The data is for the first half of the year; Morningstar said it would update for all of 2017 in the first quarter of 2018.

In a more recent read on one investment category, Goldman Sachs wrote that 49% of large-cap mutual fund managers were outperforming their benchmark, the highest number since 2009, and well above the 10-year average of 38%. In 2016, only 19% of managers outperformed.

The following tables from Morningstar show how active managers in the 12 different categories performed in the first half of 2017 compared with 2016. For some of these categories, the first half of 2017 represented the highest degree of outperformance in years.

This chart compares their performance in the first half of this year compared with other recent six-month periods.

The improved performance by active managers was partially credited to a drop in correlations, or the degree to which two different securities move in tandem. Over the past 10 years, correlations have been stubbornly high as the recovery from the financial crisis was seen as a rising tide that lifted all boats. This created a difficult environment for active managers to outperform in, as it was difficult to find undervalued names with stocks moving on macroeconomic trends rather than on their own fundamentals.

Per an analysis by DataTrek, average sector correlations were 81% between 2012 and October 2016. Last month, however, they came in at 37%, the lowest level since the crisis.

According to data from S&P Dow Jones Indices, correlation for the S&P 500 was at 0.06 in October. A reading of zero would indicate no correlation whatsoever, while a reading of 1.0 would represent perfect correlation between the index and its underlying securities.

Read more:Beneath a calm surface, the stock market is undergoing a major change

“We should see a big resurgence in active management in 2018,” said Adam Taback, deputy chief investment officer at Wells Fargo Private Bank. “We already started to see it in 2017, and we expect to see even more of it in 2018.”

Citing the fall in correlation, Taback said that “active management is in its best position of the last 10 years.”

Of course, to take advantage of that environment, investors would still need to be invested in the right active fund. Finding one that will outperform in the future can be difficult, and earlier this year, Jeffrey Ptak, global director of manager research for Morningstar, wrote that “active-fund selection belongs in what Warren Buffett has called the ‘too hard pile.’ ”

Read:It’s too hard to find a good active fund manager, so don’t bother trying, Morningstar says