By Eric Dutram, Assistant Vice President, DWS.

Eric Dutram, Assistant Vice President, DWS.

One of the greatest debates in investing is which strategy is better for outperformance: active or passive?

While this is a long-standing battle between these two sides, the arguments tend to boil down to just a couple key factors. Active investors tout their ability to avoid potential losers and zero in on top picks as a reason to choose their approach. Meanwhile, passive investors hang their hats on the generally lower costs of their technique, and its ability to avoid missing out on any big winners.

While there are plenty of emotional reasons to pick one side over another, what does the data say? After all, both strategies have been around long enough that there should be some compelling evidence pointing to a winner in one respect or another.

Which has better performance?

We took a look at 205 different rolling three year periods over the 20 years ending 31 March 2018, to see which approach—active or passive– came out on top. The results were split almost perfectly down the middle. In the large-cap blend space, active managers were able to outperform their relevant benchmarks roughly 50% of the time.

Obviously, that doesn’t indicate a clear-cut winner in the active vs. passive debate, so perhaps it would be helpful to dive a bit deeper into the data. Specifically, who wins when the market—as represented by the S&P 500—gains more than 10% or when the benchmark gains less than 10% in a given time frame?

In this scenario, clear winners emerge for both types of market environments. Best of all, the market almost evenly splits between environments when the S&P 500 gained over 10% (101 out of 205) and returned less than 10% (104 out of 205).

Markets with higher-than-average gains

In the best market environments, passive easily beats active investing, as active managers only managed to surpass their counterparts 23% of the time. Part of the reason for this could be the fact that a bull market isn’t a ‘stock picker’s market’; a rising tide tends to lift all boats. As illustrated in the chart below, all of the best rolling three-year periods were better for passive investors than their active rivals.

Additionally, as has been the case in part of the recent bull market, it has been the largest companies that have really led the charge higher. It is arguably more difficult for an active manager to add value when all of the best-known and most popular companies are the ones leading the performance cycle, rather than smaller and more overlooked names. This environment can be particularly difficult for active managers.

Source: DWS.

Markets with weaker performance

However, a nearly complete opposite situation transpires when the market isn’t roaring higher. In 80 of the 104 times that the S&P 500 gained less than 10% for the rolling three-year return, active managers outperformed their passive counterparts. This is good enough for a 77% win rate, a level that is just as impressive as passive’s dominance in bull market environments.

However, in an interesting twist, active’s outperformance is by no means relegated to a specific market environment as we saw with passive’s near total dominance in extreme bull runs. Active managers have been able to add value relative to the benchmark in a number of situations ranging from double-digit percentage declines to modest gains.

In both scenarios, part of this could be due to active managers’ ability to avoid the worst performers in a given time frame which could potentially allow for outperformance in sluggish market conditions. Indeed, active managers appear to have done the best, at least in the past, relative to indexes during the worst conditions, rarely lagging by any significant amount during the steepest declines. Avoiding the worst isn’t quite as useful during broadly positive conditions, potentially explaining active’s underperformance during better market environments.

Source: DWS.

Bottom Line

There is no one investing style that is superior. Different market environments tend to be better for certain strategies. And while past performance is by no means a guarantee of future returns, it does appear as if active management has a better chance of adding value during sluggish conditions, while pure bull markets have tilted towards passive.

I would argue that this is primarily from active managers’ nimbleness in avoiding the worst names during the most difficult market environments, as well as their apparent lack of ability to tilt towards the best performers during the most bullish periods in the market. Either way, it shows that in the active vs. passive debate, the likely winner really depends on the market environment more than anything.

Source: DWS.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)