The active versus passive debate has been front and center for most of the past 10 years. Flows to passive investments have intensified, while active management has largely fallen out of favor. According to Morningstar, $1.2 trillion has gone into passive mutual funds and exchange-traded funds (ETFs) since 2007. This imbalance has been exacerbated by low-cost passive funds’ strong returns relative to active funds, which tend to charge higher fees. Unique forces such as unconventional monetary policy, high equity correlations, low economic growth and low government spending all came together in a perfect storm that made it difficult for individual strategies—and thus, active managers like my team tended to stand out.

Now the trend is changing. Equity correlations, a measure of how closely stocks trade with each other, have declined meaningfully in the past 12 months. That indicates share prices have moved more because of stock-specific factors than broad shifts in macroeconomic conditions. While correlations are unlikely to fall further from their sub 10 percent level—which has happened only twice since 1985, for brief periods of time—continued low correlations would be a tailwind for active management as they improve the likelihood of effective security selection. At the same time, strong market breadth, represented by a large portion of global stocks posting positive returns, has also helped stock pickers who invest in companies outside their benchmarks. We believed this breadth could continue into 2018, supported by broad-based earnings gains and U.S. small cap outperformance, which was boosted by lower corporate income tax rates.

Despite a lack of stock market volatility, passive index funds posted handsome returns with minimal drawdowns in 2017. This led us to believe that 2018 would present even more favorable conditions, since volatility was likely to rise on late-cycle risks and policy uncertainty, and the fourth quarter proved us right. Although this cycle has been unique in that the Federal Reserve intervention has suppressed market volatility, removing risk management as a source of alpha, which had favored passive management throughout 2016, shifted toward an active focus beginning in 2017. This prediction proved true in 2018 and we now believe we are in the early phases of a major regime shift in markets driven by the handoff from monetary to fiscal policy and from deflation to inflation. We believe these changes favor active management and security selection, especially with the rising potential for boom-and-bust economic scenarios.

Currently, the most favorable result may come from combining active and passive strategies. Generally, active managers may outperform more often when the market is volatile than when it is not. When specific securities within the market are highly correlated or moving in unison, passive strategies may be the best way to go. Market conditions change all the time, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments.

If pursuing a “best of both worlds” approach, it is also worth noting that successful active management has historically proven more difficult within select asset classes and portions of the market, such as among the stocks of large U.S. companies. As a result, if appropriate for your situation, it may make sense to veer a bit more passive in those areas and rely more on active investing in asset classes and parts of the market where it has historically proven more profitable to do so, such as among international stocks, small cap stocks and specific fixed income instruments, such as preferreds and emerging market debt. Dynamic allocation between active and passive management using our models has outperformed static strategies.

Some investors have very strong opinions on this topic and may not be persuaded by our nuanced view that both approaches may have a place in investors’ portfolios. If your top priority as an investor is to reduce your fees and trading costs, period, an all-passive portfolio might make sense for you. In our experience, investors tend to care more about factors like risk, return and liquidity than they do fees, so we believe that a mixed approach may be beneficial for all investors—conservative and aggressive alike. As with many choices investors face, it really comes down to your personal priorities, timelines and goals.

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Mihir Patel, Randy Knopp and Timothy Baker are Financial Advisors with the Wealth Management division of Morgan Stanley in New York, NY. 

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