The combination of rising interest rates, increased volatility, growing fears of an economic downturn, and escalating trade conflict, should have set the stage in 2018 for active investment managers to shine, by using their savvy to exploit temporary pricing anomalies among individual securities in the markets. Instead, passively-managed index funds have increased their performance advantage from 2017 to 2018, The Wall Street Journal reports, as summarized in the table below.

Stock Pickers Are Losing Ground

Time Period % of Active Funds Beating Passive Funds
YTD 2018, through June 30 36%
Full Year 2017 43%

Source: Morningstar Inc., as reported by The Wall Street Journal

Morningstar's analysis covered U.S. stock funds. Passively managed funds include both index mutual funds and ETFs.

Significance for Investors

“It’s been a tough run” for U.S. equity managers, as Timothy McCusker, chief investment officer (CIO) at Boston-based investment consulting firm NEPC told the WSJ. "We expect active managers to underperform in euphoric markets. We're in the late stage of a market where fundamentals are being less rewarded," he added. The main reasons for the growing performance gap between active and passive funds in 2018 are presented in the table below.

Why Are Stock Pickers Getting Trampled?

Active managers underperform in euphoric markets
Late bull market overlooks fundamentals
Growth stocks beating value stocks
Small number of big tech companies are driving the indexes
Momentum rules the market
Long-term cost and performance advantages of passive investing

Source: The Wall Street Journal

"Passive investing has worked so well because of the dominance of growth stocks in the indices," McCusker also observed. "Growth can win for a long time, but the tide can turn," he continued. In 2017, value investing was one of the few areas where a majority of active managers beat their benchmark indexes. Critics were quick to add that value stocks, and thus value indexes, performed poorly in 2017, and thus set a low bar to hurdle.

Index mutual funds and passive index-linked ETFs have enjoyed explosive growth for two principal reasons: lower overall cost, and the fact that, historically, very few active investment managers and financial advisors have been able to beat the market consistently, if ever. Among the highest profile advocates of passive investing for these reasons is Vanguard Group founder Jack Bogle. Meanwhile, costs are being pushed down yet more, as leading sponsors of passive funds engage in a price war, per the WSJ.

Given that gains in the capitalization-weighted indexes have been propelled by a small number of giant tech companies, this has produced another disadvantage for active managers with diversified portfolios. For example, Amazon.com Inc. (AMZN), Apple Inc. (AAPL) and Microsoft Corp. (MSFT) were the biggest contributors to the total return for the S&P 500 Index (SPX) in the 12 months ended June 30, contributing one-quarter of gains, according to data from S&P Dow Jones Indices, as cited by the WSJ.

Looking Ahead

As noted above, this year supposedly offered ideal conditions for active managers to prove their worth. Instead, they are trying to explain away another year of underperformance. The experience of 2018 suggests that investors must look more closely than ever in choosing among active managers. However, as the old disclaimer warns, past performance is not indicative of future results. 

Regarding passive index-linked investing, the experience of 2018 also should illustrate how this may offer less diversification than meets the eye. The reason, as discussed above, is the huge influence that a few mega-cap stocks can exert on the major indexes.