As my son transitions to the double digits, I find one of the parenting challenges getting more difficult to balance: The use of a hands-on approach to providing direction versus a hands-off approach of allowing him to try, fail and try again. I understand the benefits of both and know that they should be used in a balanced manner, yet sometimes I favor the wrong one.
Balancing the use of both active and passive investment approaches when building a portfolio can be almost as challenging. As the economy and markets transition from a period where monetary policy has dominated stock and bond pricing to a “normalized” environment, it is possible that a transition from passive to active money management will occur as well.
Central Banks and Stock Prices
As we moved out of the deep recession in 2009, it became apparent that the normal forces in the business cycle were not going to lift the economic growth rate to a normal level. At first it was the recession itself that dampened growth. Then individuals and companies were reluctant to invest again after having gone through a deep recession. It is difficult to overstate the recession’s psychological impact on investing. This reduction in investment may be responsible for the decline in productivity over the last several years. And finally, the demographic trend of an aging baby boomer population around the developed world led to a decline in the workforce population. Because the pace at which our economy grows is nothing more than the growth in our workforce plus the growth in productivity, this combination has left us with a real economic growth rate near 2% for the last several years—nearly 60% of the long-term average.
This combination of low workforce growth and productivity is what motivated the Federal Reserve and other central banks to take such extraordinary measures to stimulate economic growth.
Over the last seven years, central banks in the U.S., Europe, Japan and even China have engaged in monetary policies meant to stimulate economic growth. The tools of monetary policy mainly include setting short-term interest rates and determining the supply of money. The long, steady decline in interest rates, orchestrated by central bankers, was meant to provide cheaper capital, making it easier for individuals and companies to borrow and invest. The increase in the money supply was generally used to purchase outstanding debt (Treasury bonds and mortgage-backed securities in the case of the Federal Reserve), which in turn lowered interest rates across all maturities. The Fed’s policy drove the Fed Funds interest rate to 0% and raised the size of the Fed’s balance sheet to almost $5 trillion from less than $1 trillion just before the recession. Still, these policies have had a hard time overcoming slow productivity and workforce growth.
As interest rates fell, investors turned to other assets both for income as well as a reasonable return on their money. This caused money to flow into the stock market, dividend-paying stocks in particular, as well as other higher-yielding investments such as preferred stocks, real estate investment trusts and utility stocks. As interest rates declined further, investors were more comfortable taking on risk to find a better real return, and this lifted stock prices. Given the fact that the third quarter of last year was the first one in eight quarters to see positive earnings growth, it seems plausible that low interest rates were partially responsible for higher stock prices rather than real revenue or earnings growth.
During the last several years, then, passive investments, otherwise known as mutual and exchange-traded funds that follow an index, became more popular. In recent years, some of these passive investments outperformed many actively managed funds. Active management involves a team of portfolio managers and analysts, who select individual investments rather than follow a basket of stocks like the S&P 500 Index. It seemed like those stocks with lower quality balance sheets and poor cash flow regularly did better than stocks with low debt to equity positions, i.e., “quality” stocks. And why not? With interest rates near zero, even poor companies could keep themselves afloat despite poor revenue and earnings growth. Of course most stock-picking managers have been taught to avoid these kinds of risky companies, so active management has underperformed.
A Transition Underway
As unemployment has declined below 5% and wage growth has risen, the Fed has been willing to begin raising interest rates, albeit slowly. (The short-term Fed Funds interest rate has risen by .50% in two moves since December of 2015, and the Fed has indicated more increases are in the cards this year.) In addition, its most recent statement suggests that with the promise of help from fiscal policy (federal government spending and tax reduction), it can begin the long process of normalizing monetary policy, meaning reducing its extraordinary measures.
As this transition in U.S. monetary policy takes place, the dispersion of stock price performance among individual stocks is likely to rise. That could mean stock selection will again be more relevant. Companies benefitting from low interest rates, but without revenue and earnings growth, will be looked upon with more skepticism. This should be a healthy change as investors will need to sort good companies from bad, sound from troubled, once again.
Active, Passive or Both
One of the sustainable benefits of the long run of outperformance for index (i.e., passive) investment strategies is the pricing pressure placed on actively managed funds. When we select investments for our clients, we consider the cost of those investments and their quality. We have seen a decline in the cost of institutional share classes (usually those that require investments of at least $10,000). Active managers recognize that the market share increase of low-cost index funds cannot be overcome if they don’t perform well and at a reasonable cost. Passive managers, too, have reduced their expense ratios. In our balanced strategy, where we use both active and passive strategies, the average cost of investing is near .5%.
Our investment philosophy incorporates the idea that there are segments of the stock and bond markets where passive investments are efficient. We also believe that there is a cycle to when passive and active strategies do best. Using our analytical tools, we determine which type of investment strategy is preferred. Our investment research team’s due diligence is then used to determine the quality of the strategies we deploy.
As monetary policy normalizes, we expect an improvement in the performance of good active managers. However, this transition may also take place slowly. We will continue to use both active and passive management when constructing portfolios.
Most days I believe that constructing a portfolio this way, to ensure successful client outcomes, is easier than finding that balance when parenting!