Tracker funds have been on an extremely strong run in recent years thanks to rising equities markets but investors should consider turning back to active strategies, according to BMO Global Asset Management. 
Passive investment funds have proved popular with investors for many years as active managers have struggled to outperform across many asset classes.
Indeed, the current period of low interest rates and accommodative monetary policy has dampened yields and forced investors into riskier assets, pushing equities higher and giving rise to passive outperformance.
Indeed, the table below shows 20 years of rolling three year periods per calendar year across nine equity sectors.
Percentage of funds outperforming the index over rolling 3yr periods by calendar year
Source: BMO Global Asset Management
“The red boxes are three years of annus horribilis for active managers, so this is less than a quarter of active managers beating the index in their respective peer group,” Rob Burdett (pictured above), co-head of the multimanager team said. “The green is the opposite, where over three-quarters are beating the index.
“There is slightly more red than green, but not many, and they are really spread out and very different by market group, by time period, so it’s very much not black and white.”
Historically the team has had 75 per cent of its US exposure in an ETF tracker. In comparison, in the UK around 75 per cent of its allocation has been to active managers.
This is shown in the above graph by the two figures circled on the right-hand side as outliers compared to the rest of the sectors.
Burdett explained: “In America only 38 per cent of active managers beat passives on a rolling three-year basis but that is obviously still a meaningful proportion of the fund industry in the most efficient market in the world.”
In the US, the efficient nature of the market and accommodative monetary policy from the Federal Reserve has made it difficult for active managers to beat the index.
Indeed, as the below shows, the S&P 500 has outperformed the IA North America index by some 30.58 percentage points over the last decade.
Performance of sector vs index over 10yrs
Source: FE Analytics
Conversely, in the UK Equity Income sector, 57 per cent of active funds beat a passive vehicle over a rolling three-year period.
“That makes sense because a passive investor doesn’t look at the balance sheet, doesn’t look at the P&L, doesn’t look at the management’s record and attitude to dividend payments and dividend cover and things like that,” Burdett said.
He added that the team is agnostic on whether to use active or passive vehicles, as the fund ranges uses either where appropriate.
However, Burdett noted that the large amount of inflows into tracker funds and exchange-traded funds (ETFs) seen last year could prove costly in the long term.
“Last year, of the net flows into the UK fund industry 103 per cent went into passive. So in other words the net of all the other sectors in the industry was outflows,” he said.
“We see this as a ‘bubble in average’ and it appears to be coming in at exactly the wrong time on a relative basis.”
Indeed, Gary Potter, co-head of the multimanager team, noted that the incredible run for passive vehicles could be coming to an end.
“In an environment where quantitative easing has been abundant and liquidity has been seriously full, markets have pushed on,” he said.
“And in that type of environment when you’ve got directional momentum liquidity driving markets, passives perform quite well because people just want to be in the market.”
Ranking of S&P 500 vs domestic equity managers, January 1970 – December 2016
Source: BMO Global Asset Management
This can be seen in the above chart, where during periods of market momentum, such as between 1982 and 1989 as well as during the late 1990s, passives have outperformed.
“We have to recognise, and I think a lot of our peers don’t, what part of the market cycle we are in,” he said.
“You get periods in time, like in the late 1990s and certainly over the last few years, where the direction of markets is largely one way i.e. up.”
However, when the environment changes and monetary policies have changed, active managers have outperformed, he said.
“What we are saying is we believe we have passed the worst for active managers,” Potter added.
“We have been through a period of 6-7 years where central banks have been easing liquidity because they had to in order to save the system.”
He said this has led to a large amount of cash being put into the system which has overflowed into equity prices.
However this the trend should begin to revert, with active managers outperforming in the coming years, Potter said.
“Central banks are starting to flex their muscles and say we are going to be withdrawing accommodative monetary policy,” he noted.
“The fact that liquidity is going to be withdrawn from the system from very loose positions means that the backdrop is going to be more challenging for financial assets.
“So as it relates to trackers we are not anti-trackers but you need to understand what the financial conditions are in the market that drive the trackers in the first place.
“We believe we have gone past the low point where the passives are outperforming actives and I would put a lot of money on the next five years that line mean reverts at least halfway up which means active managers have a good chance to do better than the average index.”