Active Mutual Funds or Passive ETFs? Here's A Better Way to Manage Risk - money flower

It's become a trite Wall Street proclamation to declare the "Death of Active Management" but however you slice the numbers, it's hard to ignore that times are changing. Our Financials team tracks historical fund flows data, for as far back as ICI tracks it, and notes that $861 billion have flowed into equity ETFs since July 25, 2012, versus outflows of -$313 billion for equity mutual funds over that same period. (See the Chart of the Day below from today's Early Look.)

In the United States, there were 9,511 mutual funds in 2016, managing assets worth approximately $16.34 trillion U.S. dollars. Domestic equity funds constituted 42% of the fund market in the United States in 2016. Meanwhile, fast-rising in popularity, passive ETFs, which seek to match the performance of a benchmark index rather than beating that index, breached the $4 trillion milestone in 2017. 

Active Mutual Funds or Passive ETFs? Here's A Better Way to Manage Risk - cum etf flow

It's no small wonder why money is flowing into passive, active managers are underperforming their benchmarks. In 2016, 66% of large-cap managers, 89.37% of mid-cap managers, and 85.54% of small-cap managers underperformed the S&P 500, according to S&P's SPIVA scorecard

Worse still, over the last 15 years, data through December 31, 2016, 92.2% of large-cap managers underperformed, while that number was 95.4% for mid-caps and 93.2% for small-caps. Unsurprisingly, more than 58% of U.S. equity funds either folded or merged during the 15-year time frame. There are just too many poor-performing active managers. So why not simply buy the index?

We think there's a better way. 

This better way that mixes elements of both passive and active management. Our Growth, Inflation, Policy (GIP) model tracks the year-over-year rate of change in U.S. economic growth and inflation both of which are highly predictive of the proper asset allocation mix. 

The goal is to capture the big picture then ask the fundamental question: Is growth and inflation heating up or cooling down? Our GDP predictive tracking algorithm, which inputs 30 economic data points per month, 90 for the quarter, spits out a forecast for U.S. economic growth and our proprietary inflation tracker suggests the future direction of inflation.

We get four possible outcomes, each of which is assigned a “quadrant” in our GIP model along with the typical fiscal/monetary policy response as a result (neutral, hawkish, in-a-box or dovish):

  • QUAD 1: U.S. Growth accelerating, Inflation slowing
  • QUAD 2: U.S. Growth accelerating, Inflation accelerating 
  • QUAD 3: U.S. Growth slowing, Inflation accelerating 
  • QUAD 4: U.S. Growth slowing, Inflation slowing

From there it's a matter of selecting the right mix of assets. For that, we have backtested data showing the asset classes that outperform in each quad. As Hedgeye Senior Macro analyst Darius Dale pointed out recently, since the data suggests we're in QUAD 1, our backtested data would suggest getting long Tech (XLK) and Consumer Discretionary (XLY) stocks:

"Specifically with respect to the trailing 20 years of quarterly observations, Consumer Discretionary and Tech have positive expected values of +4.4% and +4.0%, respectively, in #Quad1 (i.e. GROWTH ↑; INFLATION ↓), which are the first and second best return profiles across the ten GICS Level 1 sectors."

We're launching a product, ETF Pro, that's essentially a list of specific ETFs with analysis to take advantage of our modeling of the U.S. economy. Click here to learn more and get updates when this essential risk management tool goes live.