FIRST QUARTER 2017

White Paper

The cyclical nature

of active & passive investing
Reporters often prepare obituaries in advance for ailing celebrities
so that when the end comes, they can publish instantaneously. Key Points
Occasionally, someone hits publish prematurely, posting tributes for The performance of active and
passive management has been
public gures who are very much alive. cyclical, with each style trading
periods of outperformance.
In the same way, much ink has been hastily spilled recently in Market corrections are a regular
and unavoidable part of market
obituaries for active management. Most of the negativity has
cycles.
focused on the rise of passive investing, which has enjoyed strong Active management has
performance during the past ve years. But simply because one style typically outperformed passive
management during market
of investing has come into favor does not mean others are going the corrections, because active
way of the dodo. managers have captured alpha1
as the market recovers.

So why are so many pundits ready to write o active management?

And what makes us so sure that investing actively is not only a viable
but essential part of investor portfolios?

1 Themeasure of the performance of a portfolio after adjusting for risk. Alpha is NOT FDIC INSURED MAY LOSE VALUE
calculated by comparing the volatility of the portfolio and comparing it to some NO BANK GUARANTEE
benchmark. The alpha is the excess return of the portfolio over the benchmark.

1
 White Paper

What Have You Done For Me Lately? From 2000 to 2009, active
Recency bias is the tendency to believe that recently observed patterns outperformed passive nine
will continue into the future, and its a powerful force that can inuence out of 10 times.
investor decisions. But investors who only take recent performance into
account are missing the forest for the trees. After all, yesterdays events FIGURE 1
shouldnt determine how tomorrows investment decisions are made. No Clear Winner in Active vs. Passive
Large-Cap Funds
Morningstar Large Blend is the largest Morningstar category, with $1.98
Winner
trillion in net asset size, constituting 16% of the U.S. mutual fund market.2
We selected this category because it is widely believed to be the most Active
ecientthe one in which active investing supposedly makes the least Large Blend S&P 500
Categor y (%) Index Funds (%)
sense. To represent active, we removed all index funds and enhanced index
1985 29.52 30.4 8
funds. For passive, we used the Morningstar S&P 500 Tracking category.
1986 17.99 16.82
As shown in FIGURE 1, passive large-blend strategies have outperformed 1987 2.80 4.13
active large-blend strategies in four of the last ve years, which helps to 1988 15.94 15.52
explain why in 2016 passive U.S. equity funds had inows of $239 billion, 1989 27.59 29. 32
while more than $249 billion under active management headed for the 1990 -3.37 -3.27
exits. 3 1991 32 .56 29.29
1992 9.56 7.01
But the past ve years only tell part of the story. A wider look at the 1993 12 .69 9.45
chart reveals active and passive have traded the lead in performance 1994 - 0.81 0.83
1995 33.21 36.72
over time like two evenly matched racehorses. From 2000 to 2009, active
1996 22.25 22 .41
outperformed passive nine out of 10 times. During the decade before
1997 30.15 32 .6 4
that, passive outperformed active seven out of 10 times. And over the 1998 20.18 28.15
course of the past 32 years, active outperformed 15 times, while passive 1999 18.72 20.28
outperformed 17 times. 2000 0.16 -9.47
2001 -7.98 -12.37
Weve seen that the cyclical nature of active vs. passive investing denitely 2002 -20.47 -22.48
applies to the Morningstar Large Blend Category. The same holds true 2003 29.21 27.91
for other investment categories such as mid-caps, small-caps, and global/ 2004 11.03 10.30
international equities. And just like performance, investor sentiment 2005 6.86 4.39
2006 14.70 15.17
moves in cycles. If a certain style or asset class is doing well, investors
2007 6.76 4.95
are quick to extol its virtues and pour their money into it. Its no surprise,
2008 -36.93 -37.27
then, that passive investing is the new darling of many investors and
2009 28.62 25.97
much of the nancial press. But just as a marathon isnt decided by the 2010 14.28 14.4 8
nal 100 yards alone, we believe the dismissal of active management 2011 - 0.66 1.59
based on recent performance alone could be imprudent. 2012 15.16 15. 39
2013 31.96 31.68
2014 11.02 13.06
2015 -1.12 0.85
2016 9.99 11. 39

Data source: Morningstar, 1/17

* Active Large Blend is made up of funds from the
Morningstar Large Blend category that are not index or
enhanced index funds.
* S&P 500 Index Funds is represented by the Morningstar
S&P 500 Tracking Category.

2,3 Source: Morningstar Direct, 1/17

All investments are subject to risks, including the possible loss of principal. Performance data quoted represents past
performance and does not guarantee future results.

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 White Paper

Active or Passive? Yes.

Active Share: The True Measure for Active Managers
Like the ocean tides, active and passive managements
performance ebbs and ows. And as FIGURE 2 When it comes to active and passive, the debate isnt as
simple as an either/or choice. Many so-called active funds
demonstrates, their performance cycles are clearly
closely mirror the indexes that serve as their benchmarks.
dened. The chart compares the rolling monthly 3-year These closet indexers oer no real value to active investors,
performance percentile rankings for active managers and instead aim to slightly outperform the index by including
with that of passive managers ranked within the a few dierent names. The problem, of course, is that this
modest objective may not oer a real upside to justify the
Morningstar Large Blend category.
fees associated with active management.
FIGURE 2 shows that while overall there is no clear Investors who are looking for a true active manager
winner over the past 30 years, there has been a should examine the funds active share, or measure of the
percentage of equity holdings in a managers portfolio that
clear winner in active vs. passive performance for dier from the benchmark index. By examining active share,
multiple and sustained periods, followed by a trading investors can get a clearer picture of how an active manager
of positions. Once again the recent outperformance is adding value, instead of relying upon returns alone. Its a
of passive is evident, and is preceded by 10 years of critical metric when trying to determine which funds are truly
active or passive.
dominance by active management, and so on.

The story that FIGURES 1 and 2 tell is clear. Just when The Active-Share Spectrum
it seems that active or passive has permanently pulled
ahead, markets change, performance trends reverse, INDEX CLOSET INDEXER ACTIVE
and the futility inherent in declaring a winner in active 0% 20% 40% 60% 80% 100%
vs. passive is revealed anew.

FIGURE 2
Active and Passive Outperformance Trends Are Cyclical
Morningstar Percentile Rankings Large Blend Category

10

20

30

40

50

60

70

80
Actively Managed Large Blend Passively Managed Large Blend
90
12/31/85
12/31/86
12/31/87
12/31/88
12/31/89
12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
12/31/98
12/31/99
12/31/00
12/31/01
12/31/02
12/31/03
12/31/04
12/31/05
12/31/06
12/31/07
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
12/31/14
12/31/15
12/31/16

12/31/1985 to 12/31/2016 Rolling Monthly 3-Year Periods

Data Source: Morningstar, 1/17

2,500

3 43% Higher
 White Paper

Home Runs: Part of the Cycle In FIGURE 3, weve ranked the past 32 years from highest
to lowest in terms of which stocks within the S&P 500 Index
Active/passive cyclicality is further demonstrated with high
had the most home runs. The average number of home
and low amounts of stock home runsthat is, a stock that
runs during this time period was 213. Sure enough, in years
outperforms the benchmark by 25% or more. Markets that
that feature a high number of home runs, active tended to
feature large amounts of home runs signal dispersion in stock
outperform. And when there were fewer standouts, passive
returns. High dispersion should benet active managers who
was the clear winner. Its just another example of how
can single out the winners, whereas a low number of home
the performance of active and passive management has
runs indicates stocks are moving together, which typically
remained faithful to cyclical trends.
benets passive management.

FIGURE 3
Active Managers Have Generally Outperformed in High Dispersion Markets
S&P 500 Index (1985 - 2016)

Active Outperforms
Home Runs % of HR % Active Outperform
2001 322 63% 70%
2000 305 59% 79%
1992 269 53% 61%
2002 272 53% 63%
2004 264 52% 56%
2010 253 50% 43%
2009 258 50% 61%
2005 243 48% 76%
2016 242 47% 31%
2011 232 46% 25%
2015 233 45% 28%
2014 231 45% 25%
1993 226 45% 64%
1994 227 4 4% 33%
1986 211 43% 53%
2007 218 43% 63%
1988 210 42% 55%
2003 209 41% 48%
1991 205 41% 56%
1987 201 41% 42%
1990 203 40% 51%
2013 198 39% 54%
1985 186 38% 40%
2012 182 36% 51%
2006 180 36% 46%
2008 184 35% 52%
1989 175 35% 35%
1997 155 30% 27%
1996 151 30% 43%
1999 135 26% 41%
1995 125 25% 24%
1998 114 22% 19%
Average 213 42%

Past performance is not indicative of future results. Indices are unmanaged and not
available for direct investment.

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 White Paper

Active, Passive, and an Aging Bull

So what does cyclicality in active and passive management Like broad equity indexes, individual sector valuations have
performance mean for you, the investor? We believe it been on the rise. The S&P 500 Index has a historical price/
demonstrates the importance of maintaining perspective earnings ratio (the ratio of a stocks price to its earnings per
(and sight of your investment goals) over time, and share) of 18 and, as of the publication of this piece, that
minimizing the undue inuence of ckle market sentiment ratio had climbed above 20. FIGURE 5 reveals that the price/
as you navigate changing market cycles. Instead of letting earnings ratios of eight out of 11 sectors of the S&P 500
recent performance enchant you into chasing returns, you Index are trading above their long-term average.
should instead consider current market conditions and what
the future could hold. While this bull has run freely for years, it hasnt been
immune to occasional corrections (as measured by a loss
As shown in FIGURE 4, the current bull market in equities of 10% or greater) to help keep it healthy. Like speed limits
reached the nine-year mark, making it the third-longest bull on highways, market corrections are a necessary evil in
market on record.4 Not only that, the value of the S&P 500 investing, but not one to be feared. They keep markets from
Index has more than tripled since its low in March 2009.5 becoming overinflated and prevent valuations from reaching
0
The NASDAQ composite reached 5000 for the first time in 15 heights that lead to damaging crashes. They can also provide
years. The last time the NASDAQ reached such lofty heights?

-14.94
opportunities
-10 for active management, as well explore next.
During the peak of dot-com exuberance in 2000.
-20

-15.21
-30
0.26
-40

-50

-60
aged Large Blend Passively Managed Large Blend Active Strategy Average
-70
12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
12/31/98
12/31/99
12/31/00
12/31/01
12/31/02
12/31/03
12/31/04
12/31/05
12/31/06
12/31/07
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
12/31/14
12/31/15
12/31/16

Passive Strategy Average

FIGURE 4 FIGURE
-80 5
Equity Valuations Have Risen Steadily for Nine Years Many Sector Valuations Are Above Historical Averages
S&P 500 Index Price Only (12/31/99-12/31/16)
30 Yr
S&P 500 Sectors 12.31.16 % Change
2,500 0 Avg P/E
Consumer
18.05 20.22 12%
43% Higher Discretionar
-5 y
Consumer Staples 21.06 23.31 11%
Index Level (Price Only)

2,000 -10

Price High in 2007 Energ y 16.85 33.71 100%

-15
Financials 13.96 15.80 13%
1,500 -20
Health Care 22.33 19.58 -12%
Industrials
-25 18.03 20.84 16%
Information
1,000 -30
23.35 21.29 -9%
Technolog y
-35
Materials 17.89 20.75 16%
500 Real
-40 Estate 28.74 40.78 42%
12/99

12/00

12/01

12/02

12/03

12/04

12/05

12/06

12/07

12/08

12/09

12/10

12/11

12/12

12/13

12/14

12/15

12/16

Telecommunication
19.97 15.67 -22%
Ser vices
-14.94
Utilities 15.4 40.26 -15.21
21.03 36% Dates
Data Source: Morningstar, 1/17
Total Active Strategy Average
18.10 20.21 12%
Passive Strategy Average

Data Source: Fac tSet, 1/17

Current P/E ratio is as of 12 /31/16

4 Source: Ned Davis Research, 2/17

5 Source: Morningstar, 1/17

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 White Paper

Active Management Has Fared Better During FIGURE 6

Corrections Active Management Has Taken Corrections in Stride
The most recent market correction arrived in November Active Passive
of 2015. When corrections occur, you may not want to be Date Strateg y Strateg y % Dif ference
Average % Average %
exclusively invested in passive. Instead, you may want to
consider investing in actively managed funds. 08/26/1987-
-15.93 -17.36 1.4 4
10/19/1987
There have been 22 market corrections over the last 30
10/22/1987-
years. FIGURE 6 shows that during those corrections, active -14.28 -14.37 0.09
10/26/1987
outperformed passive 16 out of 22 times, with an average
11/03/1987-
rate of outperformance of 0.79%.6 Again, we compared -9.72 -10.55 0.83
12/04/1987
active to passive by removing index and enhanced index
funds from the Morningstar Large Blend Category to 07/17/1990 -
-18.74 -18.57 - 0.18
10/11/1990
represent active, and used the S&P 500 Tracking category to
represent passive. 10/08/1997-
-9.08 -10.66 1.58
10/27/1997
By allowing investors to respond to ever-changing markets,
07/18/1998-
active management empowers investors to maximize -19.88 -18.52 -1.35
08/31/1998
opportunity as conditions demand. But if youre locked into
07/17/1999-
an index fund, you could be exposed to signicant downside -11.86 -11.88 0.01
10/15/1999
due to single-sector performance. For example, during the
collapse of the dot-com bubble in 2000, active management 03/25/2000 -
-10.23 -11.13 0.90
04/14/2000
outperformed passive signicantly, 0.2% to -9.50%.7 Much of
the blame for passives underperformance during that period 09/02/2000 -
-20.00 -27.12 7.12
can be laid at the feet of a single sector. 04/04/2001
05/22/2001-
As FIGURE 7 shows, the technology sector made up almost -24.83 -26.22 1. 39
09/21/2001-
30% of the S&P 500 Index at that time. The sector (as
03/20/2002-
represented by the S&P 500 Information Technology Index) -28.53 -31.59 3.06
07/23/2002-
crashed hard, to the tune of a 38.71% decline in 2000.
08/23/2002-
Meanwhile, the average active manager was signicantly -18.40 -19.08 0.69
10/09/2002-
underweight technology relative to the index (21% vs. 30%),
11/28/2002-
which helped limit the damage done to their portfolios when -13.36 -14.36 1.00
03/11/2003
the tech bubble burst. Active managers with a positive return
10/10/2007-
during this time were more underweight to technology with -16.87 -18.10 1.23
03/10/2008
15%, and those with a negative return hewed closer to the
05/20/2008-
index with a 28% weighting.8 For a more recent example, one -36.47 -36.53 0.05
10/10/2008
need only look back to the decline in oil prices in 2014 to see
how passive investors were hurt by their inability to reduce 10/14/2008-
-15.81 -15.43 - 0.39
10/27/2008
exposure to an underperforming sector.
11/05/2008-
When bull markets inevitably turn, passive managers could -24.64 -25.00 0. 35
11/20/2008
be left holding stocks and sectors with poor fundamentals
01/07/2009-
and inated valuations. Meanwhile, active managers have the -25.37 -27.22 1.85
03/09/2009
ability to mitigate risk by reducing exposures to expensive
04/24/2010 -
areas that will be hit hardest, and conversely, increase -15.78 -15.72 - 0.07
07/02/2010
exposure as sectors or asset classes recover to capture upside
as the new market cycle begins. 04/30/2011-
-20.46 -18.83 -1.63
10/03/2011
07/21/2015-
-11.60 -12.06 0.4 6
08/25/2015
11/04/2015-
-13.88 -12.83 -1.05
02/11/2016
Average Outper formance 0.79
6 Source: Ned Davis Research, 1/17 Active Wins 16
7 As represented by the S&P 500 Index, from 1/1/00 to 12/31/00 Passive Wins 6
8 Source: Morningstar, 1/17
Source: Fac tSet, Morningstar

6
 White Paper

FIGURE 7
Index Funds: Individual Sectors Can Have Outsized Impact
1/1/2000 to 12/31/2000 S&P 500 Index Sectors

Sector % Average Weight % Total Return % Impact on Performance

Consumer Discretionar y 9.85 -23.75 -2.67
Consumer Staples 8.78 5.95 0.50
Energ y 6.49 20.04 1.11
Financials 14.04 25.40 3.11
Health Care 11.57 37.93 3.58
Industrials 8.82 3.36 0.16
Information Technolog y 29.59 -38.71 -11.82
Materials 2.02 -16.22 - 0.38
Real Estate 0.10 -26.65 - 0.03
Telecommunication Ser vices 6.75 -38.82 -3.02
Utilities 1.98 53.59 0.80
Total 100.00

Data Source: Fac tSet, 1/17

Investment Implications: The performance of active and passive management

This white paper focused on active vs. passive investing in
the Morningstar Large Blend category because its widely
believed to be the most efficient categorythe one that
should invariably favor passive investing. Yet even this
category shows the cyclical nature of active and passive
performance. The same cyclicality is present in other
investment categories such as mid-caps, small-caps, and
global/international equities.
is cyclical, meaning each style goes through extended
periods of outperformance.
When evaluating active and passive management, looking
beyond recent performance and measuring active share is
important.
As we saw in November 2015, market corrections are
inevitable and a common occurrence in equity markets
over time.

Just as we think declaring active management dead is
premature, we dont contend that active management is the
only suitable choice for investors. Far from it. We believe
that the choice between active and passive management is
not a zero-sum game, but that each has a place in investor
portfolios based on the individual needs and wants of the
investor. With that in mind, here are some conclusions to
take away from this piece:
There have been 22 market corrections over the past 30
years, and active management outperformed passive
management in 16 out of 22 corrections.
During market corrections, the exibility of active
management allows for reducing exposure on the
downside and ramping up exposure to capture alpha
in the early stages of recovery.

7
This information should not be considered investment advice or a All investments are subject to risks, including the possible
recommendation to buy/sell any security. In addition, it does not take into loss of principal.
account the specific investment objectives, tax and financial condition
of any specific person. This information has been prepared from sources Hartford Funds Distributors, LLC, Member FINRA.
believed reliable but the accuracy and completeness of the information WP287_0317 200337
cannot be guaranteed. This material and/or its contents are current at the
time of writing and are subject to change without notice. This material may
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