A new era for active investing emerges

In building resilient portfolios, all decisions are active – the debate about active management vs. passive management is no longer a binary decision. Each approach has its own advantages, and different market environments may benefit one over the other. Most importantly, every investment decision should be intentional, and active management is good risk management.

For more than a decade, the median active manager has had difficulty outperforming index strategies, especially in large, liquid public equity markets. Persistently low risk-neutral yields and muted inflation risk premia in the wake of the global financial crisis (GFC) coincided with, and may have contributed to, a period of underperformance and increased cyclicality in active manager returns. At a time of depressed interest rates, low market volatility and higher correlations, exposure to passive market beta was a winning formula.

But these conditions are changing. Looking out over the 10- to 15-year investment horizon of our Long-Term Capital Market Assumptions (LTCMAs), we see greater two-sided risk to inflation, ongoing central bank policy normalization and rapid technological innovation increasing market volatility and improving the prospects for active investing. Higher investment spending combined with higher capital costs will create clearer winners and losers among businesses operating in a more complex environment. Without the rising tide of cheap capital from central banks keeping all boats afloat, skilled managers should be able to capture idiosyncratic returns.

Realizing the benefits of active management relies on thoughtful manager selection, disciplined portfolio construction and effective risk management. To maximize active management’s potential, investors should embrace a forward-looking approach and leverage diverse sources of excess return (or alpha) to build resilient portfolios that capitalize on the shifting market environment.

Redefining the active-passive continuum

In recent years, the debate about active vs. passive management has evolved into a more nuanced discussion. The two investing styles are now seen as opposite ends of a spectrum: Each approach has its own benefits and challenges, and outcomes vary depending on market conditions and investment objectives.

For our purposes, we define active management broadly, incorporating all approaches where the goal is not full replication of a market cap-weighted index. This includes the spectrum from smart beta and alternative weighting schemes to concentrated active portfolios. In our view, this inclusivity better reflects the toolkit that investors currently have at their disposal to achieve their portfolio objectives.

Importantly, there is no one-size-fits-all approach. Investors can use fundamental and systematic active strategies to exploit research insights and enhance returns; smart beta to harvest compensated risk premia; and market cap-weighted passive strategies to implement strategic or tactical asset allocation views in a cost-effective way. In taking this view of active investing as a continuum of differentiated risks, it becomes easier to weigh the relative merits of active strategies when constructing portfolios – and to lean into those that can help diversify risks and enhance returns.

Opportunities for active vary across asset classes and market conditions

In recent periods, the median active manager has faced challenges¹ in the larger, more liquid U.S. public equity market peer groups (Exhibit 1). Within these peer groups, strategies that expand the breadth of their investment processes, such as extension strategies (where managers can take both long and short views on specific stocks), have fared better. Additionally, active managers have performed well in less efficient equity asset classes, such as small cap and emerging markets. In fixed income, index construction – which often excludes large market segments and overweights the most indebted issuers – has created a structural tailwind for active managers.²

As noted in our own research,³ even successful active managers are subject to intermittent performance stressors over time, including:

• Alpha cycles: Successful active managers with strong long-term track records will still likely experience periods of underperformance, suggesting that short-term outcomes may not reflect long-term potential.
• Market conditions: Active managers tend to perform well when market returns are weak or rising by single digits but may struggle when market regimes change abruptly – even during sharp equity rallies.

As a consequence, allocators and end investors have experienced difficulties in realizing the full potential of active manager performance. Across time periods and asset peer groups, average manager returns have been markedly higher than the end investor experience (Exhibit 2). The reason is straightforward: Capital flows tend to suffer from recency biases, with assets following performance. As a result, asset-weighted performance suffers.

The key to capturing the benefits of active management lies in maintaining discipline through cycles. Instead of reacting to short-term underperformance, investors need to pay attention to manager performance in the context of market drivers, focusing explicitly on whether strategy performance is aligned with its stated process and philosophy. Furthermore, leaning into underperforming managers during periods of underperformance can be beneficial if conviction in the team, process and philosophy remains.

Understanding active performance drivers

For decades, academics and industry participants have sought to unpack the drivers of active management performance.⁴ Our analysis suggests that both market structure and macro factors, combined with regime-specific nuances, have explanatory power.

As part of our ongoing proprietary research, we analyze industry data to assess how market conditions and macro variables affect active manager returns. Our work begins with commonly cited academic research on the potential drivers of active outperformance specifically related to market conditions. These drivers broadly fall into two categories:

• Implied volatility measures market expectations of changes in a security’s price and tends to rise during periods of market turbulence. As markets become more volatile, the rationale suggests, active strategies can invest more proactively and exploit emerging dislocations between prices and fair value.
• Security correlation relates to performance dispersion within an asset class. Examples include market index concentration and relative performance across investment styles. Clearly, if securities’ returns within an index are more dispersed, an active strategy has greater opportunity to outperform its underlying benchmark.

We also analyze performance drivers by regime, finding that many of the drivers of average manager performance differed in magnitude and direction, depending on the regime. The explanatory power of macro and factor variables is stronger for individual regimes than for the entire time period.

These dynamics drive active manager alpha cycles. Specifically, managers that follow a disciplined investment process will periodically experience regime-specific headwinds. Understanding the macro and micro drivers of manager performance can help investors navigate cycles and avoid behavioral mistakes.

From structural headwinds to potential opportunity

The growth of passive management has made equity markets more cyclical and reliant on a few large stocks, reducing the impact of company fundamentals (Exhibit 3). This can lower index volatility during steady inflows, but it increases index fragility in stressed markets. For active managers in this environment, leaning against momentum becomes more difficult – any contrarian positioning is riskier.

Exhibit 4 illustrates this dynamic by depicting the correlation between net flows into S&P 500 exchange-traded funds (ETFs) and the performance of the momentum factor. Periods of elevated passive flows are closely associated with stronger momentum factor returns, underscoring how index-driven demand amplifies price movements in select stocks.

The same mechanism that drives stock prices upward through synchronized inflows can rapidly reverse, however, creating opportunities for active managers. In periods of market stress, redemptions from passive funds can lead to indiscriminate selling, creating a liquidity vacuum with few natural buyers. In such environments, mechanical outflows push prices away from their fundamental values, presenting skilled active managers with useful entry points.

These structural shifts – characterized by momentum bias, reduced diversification and synchronized flows – diminish overall market efficiency but simultaneously generate cyclical investment opportunities.

Conditions favor active management

Although we do not expect a wholesale reversal of the indexed approach to equities, our LTCMAs suggest that macro and market conditions look very different than they did in the post-GFC period. As economic nationalism and fiscal activism become more entrenched, we expect them to increasingly impact market dynamics over the coming decade.

For active investors, these shifts may prove beneficial. Looking out over our 10- to 15-year investment horizon, we do not expect to see a repeat of the macro conditions that suppressed market volatility and stock dispersion post-GFC. As noted earlier, we anticipate more two-sided risk to inflation, increased geopolitical tensions and central bank policy normalization. These changes will create opportunities for active investors to exploit market inefficiencies and capitalize on mispricings.

The rise in fiscal activism that we identified in last year’s LTCMAs, combined with a meaningful increase in tariff- and artificial intelligence (AI)-related corporate investment, further supports our view. Additionally, a shift from capital investment and technology adoption to deployment across various sectors will redistribute growth and create new winners, providing fertile ground for active security selection.

Quite apart from its macro implications, widespread technology adoption is also driving the asset management industry’s evolution. The rise in active ETFs, an increasing emphasis on tax efficiency and faster AI adoption are creating a tailwind for asset managers with the scale and resources to capitalize on these changes. Sophisticated, AI-enabled portfolio construction tools are proliferating, democratizing analytical methods that once were restricted to large asset owners and allocators.

Structuring resilient portfolios

Building portfolios requires intentional, active decision-making at every stage, from setting objectives to choosing benchmarks. On this point, it’s important to think through the trade-offs for end constituents when building a portfolio: For example, what matters more, higher alpha or a smoother experience? These considerations can help guide investors in determining the desired amount of active risk in the portfolio.

Here, we look at four nuanced considerations that often challenge investors:

1. Market efficiency: Given the prominence of U.S. equities in many investors’ strategic asset allocations, even modest outperformance by active managers can materially benefit investment portfolios. In light of our outlook, we suggest maintaining some active exposure within U.S. equities.

2. Investment utility: Active management’s value goes beyond excess returns; it also provides diversification, downside protection and income. As investor goals become more complex, evaluation methods should reflect these broader benefits.

3. Performance metrics: Investors should use a variety of performance metrics – such as rolling returns, risk-adjusted results and utility-based criteria – rather than focusing solely on excess returns, to avoid short-term biases and make better decisions.

4. Time horizons: Active managers employ strategies with varying investment horizons, making it essential to tailor evaluation criteria to a strategy’s process. Evaluating all managers using the same parameters can create a rigid structure – and raise the potential for miscalculations.

Since manager headwinds and tailwinds vary by market regime, focusing on truly differentiated, structural alpha drivers may be the best way to ensure alpha diversification. In building resilient portfolios, it’s vitally important to balance distinct sources of alpha with appropriate levels of overall active risk to achieve return objectives. What would this entail? On a practical level, investors can use portfolio construction techniques such as risk clustering to identify truly differentiated sources of excess return; more directly, they can deploy a combination of fundamental and systematic investment processes (Exhibit 5).

Investors should use fundamental strategies to incorporate depth into their portfolios through rigorously researched, forward-looking views. Investors can then apply systematic processes for breadth to identify – at scale – securities with attractive characteristics, such as cheap valuations, high quality and strong momentum.

With regard to balancing diverse sources of alpha, we see a shift in institutional investor behavior as allocators continue to look for ways to move beyond the limitations of a 60/40 stock-bond portfolio to maximize return and diversification. Specifically, allocators with the expertise and resources to implement sophisticated hedging programs are exploring portable alpha solutions, maximizing capital efficiency and diversification by removing the constraints of cap-weighted investing.

Expanding the opportunity set in this way can be a productive and efficient use of capital. For example, the information ratio for top-quartile U.S. equity active managers is just .37, compared with .57 for developed market international small cap managers (Exhibit 6). By expanding the opportunity set, enhancing returns and reducing volatility, allocators are better able to avoid behavioral pitfalls and – ultimately – maximize time in the markets.

Conclusion

Active investing spans every investment decision, each of which has material implications for investor outcomes. There are many ways to leverage both active and passive management; investors can and should use both.

In the changing macro environment, we expect capital to be in motion, driving differential outcomes and investment opportunities. In the absence of noneconomic market participants (namely central banks), price discovery will likely become more efficient, benefiting active managers that emphasize business fundamentals.

Over many market cycles, we have observed that successful portfolio design hinges on thoughtful manager selection, portfolio construction and effective risk management. By embracing a forward-looking approach and leveraging diverse sources of alpha, investors can build resilient portfolios that make the most of an evolving market.

As is the case across our research insights, we will continue to build on our body of work in this area. Our specific areas of focus will be: analyzing the efficacy of highly concentrated managers; diving into regional nuances within the context of commonly accepted beliefs of market efficiency; and detailing the implications of fees and liquidity for alpha as the lines between public and private assets become increasingly blurred.

¹ Within the U.S., funds with diversified status under the Investment Company Act of 1940 cannot fully weight all stocks in the Magnificent 7, creating a structural headwind to manager alpha in recent periods.

² Frequent changes in liquidity and credit ratings, which can force passive managers into costly trades, also provide tailwinds for active fixed income managers.

³ Michael Cembalest, “A Search for Intelligent Life in the Active Universe,” J.P. Morgan Asset Management, 2014.

⁴ We note the publication of Eugene F. Fama and Kenneth R. French’s research on orthogonal risk premia, “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics 33, no. 1, February 1993.