The other day I came across an issue of Barron’s, dated January 10^th 2015. The front page headline was titled, “Return of the Stock Pickers.” But it didn’t happened in the intervening six years nor has it in the past 15! The reason is, interest rates haven’t change. Fed funds have stayed at 0% because the two crises – financial and then Covid-19 – happen over that time period. For stocks, it’s been similar to the proverbial theater fire; each individual enters the theater one at a time, but when someone yells “fire,” they all get up and leave together. The stock market has traded that way for years.

Unchanged Fed funds is the reason for underperformance of active management, not the 1% management fee. The secular direction of interest rates is what drives outperformance up or down. When rates decline – as they have for the past 39 years - underperformance is the result; when rates move higher, it creates opportunity for active management to outperform. Outperformance for active managers last happened in the 27 year cycle of 1955-1982. Funds moved from 1.8% to 20% in that inflationary time frame. Yet it was a period that made many active portfolio managers billionaires.

So the real question is why. The answer is twofold:  rising rates create higher dispersion between the best and worst performing stocks and secondly, it lowers correlation. Both are essential in creating active outperformance. For the past 15 years – with Fed funds at 0 - stocks have traded as though they are one major asset class such as blocks of coal. High frequency trading and indexation have further obfuscated price discovery. With the Covid-19 crisis, the Fed has kept rates low by monetizing 120 billion of U.S. treasuries each month. It has had the unintended result of hurting active management.  

If an active manager is aware of this, why wouldn’t he simply put his clients in a passive fund until a change in interest rate direction? There are more than a few reasons besides timing. Foremost is his fiduciary responsibility in managing a separate account. He must act as though the client’s money is his own. No one who is an active fiduciary manager, and over the age of 50, would put 25% of his money into five of the most expensive capitalization weighted FAANG stocks in the S&P 500. Pooled account (hedge fund, mutual fund) maybe. Separate (individual) account. Never! They know the risk.

The 39 year secular bull market in fixed income is close to over. Active portfolio management’s return will begin when the Fed starts tapering its 120 billion a month purchase of U.S. bonds. A strategy that has artificially elongated the time frame of the bond market’s three generational cycle and added to the absurd buildup of seven trillion in passive stock funds. This long interest rate decline created a positive feedback loop for passivity further reducing price discovery; one that will turn into a negative feedback loop as interest rates move higher. Money will flow out of passive funds quickly. The bear market last March was a demonstration. It was the fastest in history moving down 34% in 33 days!

By contrast, the last secular bear market in fixed income started 56 years ago in 1965. The average American has never experienced a bear market in fixed income. One that resulted in the Dow Jones Average going sideways for 17 years. Barron’s, to its credit, did acknowledge in its cover story that … “rising rates go hand-in-hand with outperformance of smaller stocks, which active managers tend to favor.” That statement is also a key to outperformance by active managers. Small cap is driven by passionate entrepreneurs while large cap is ruled by macroeconomics, such as declining interest rates.    

Francis Patrick Boland