The debate over active vs. passive stock investing has been raging for years. Compelling arguments are made for each side. It is more complicated than it may seem. In addition to the money manager’s skill, prevailing market conditions will raise or lower the odds of an active strategy beating indexing.

Factors to watch

Market conditions, or internals, include the dispersion of returns within an index and the correlation of those returns. Simply put, when there is more differentiation between the stocks in an index, it creates a more favorable environment for active management.

Then there is market breadth, which is simply the number of stocks that are advancing versus the number of decliners. The concept is straightforward: If a majority of stocks are outperforming their index, then statistically the odds of picking winning stocks are higher. Conversely, if only a few stocks are outperforming, then the active manager has to pick from just those few stocks to add alpha.

The link between breadth and active-passive investing

Going back to 1991 (as far back as Morningstar data on active vs. passive goes), we see that on average the percentage of stocks outperforming the S&P 500 on a 12-month basis is 50%. That makes sense, of course. It is positive (above 50%) 53% of the time and negative 47% of the time.

When relative breadth is positive, the median three-year excess return of active strategies over passive is +0.04%. But it gets more interesting. When the market gets broader and relative breadth gets more positive, say at 55%, active outperforms passive by +0.99% on a three-year rolling basis, and it does so 78% of the time. When relative breadth gets very positive, say at 60%, then active beats passive by +2.35%, and does so 100% of the time.

How often does this happen? Relative breadth above 55% has happened 32% of the time since 1991 and 23% of the time since the start of our breadth data, in 1927. Relative breadth above 60% has happened 11% of the time since 1991 and 8% since 1927.

Conversely, when the market gets narrower and relative breadth falls to 45% or below, active underperforms passive by -2.05% on a three-year basis, and does so 79% of the time. When breadth gets even more narrow and falls to 40% or below, active underperforms passive by -2.8%, and does so 97% of the time. How often does this happen? Relative breadth below 45% has happened 31% of the time since 1991 and 41% of the time since the start of our breadth data in 1927. Relative breadth below 40% has happened 16% of the time since 1991 and 20% since 1927.

The chart below shows the relationship between relative breadth and the excess return of active over passive.

The higher the relative breadth percentage, the greater the tendency for active to outperform passive.