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ACTIVE INVESTING IS NOT DEAD, BY GEORGE!

JUNE 2017BY ADAM T. EAGLESTON, CFA

OPUS CAPITAL MANAGEMENT221 East Fourth Street, Suite 2700 Cincinnati, Ohio 45202p (513) 621-6787f (513) 639-3072

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Active investors have been uttering oaths a lot more colorful than “by George!” over the last few years. With flows moving from active to passive at unprecedented levels, it has certainly been a challenging time for active managers.

However, we remain as convinced as ever in the future of active management, and by Georges (Patton, Orwell, Carlin, and Soros), we are going to prove it!

Patton versus PassivismFew American military commanders were as controversial as General George S. Patton. Born 1885, and with ancestors that fought in the Revolution, Mexican and Civil War, he decided from an early age he was destined for military greatness. He competed in the 1912 Stockholm Olympics in the first modern pentathlon (pistol shooting, fencing, 300 m freestyle swim, 800 m horseback and 4 km cross country run). He was the first member of the United States Tank Corps, and served until the corps was abolished in 1920, always believing tanks were the future of modern combat.

Patton was known for his bombastic leadership and flamboyant style, which included carrying pistols with ivory handles. A student of history, in part due to his belief in reincarnation, we invoke the memory of this iconoclastic general as we, too, look at history and take a controversial stance – that active management is not dead, and is destined for greatness over the coming years.

The Battle of the BulgeFund flows into passive have been enormous, forming a bulge not seen since the Allies rapidly advanced toward Germany in the winter of 1944.

“When it came to funds that focused on U.S. stocks, there was nearly a dollar-for-dollar switch: Passive funds brought in a record $236.7 billion in investor cash, while their active counterparts saw $263.8 billion go out the door, worse even than the $208.4 billion in outflows during the height of the financial crisis in 2008.” (Jeff Cox at cnbc.com; January 19, 2017)

The prolific proponents of passive investing, “passivists” as we propose calling them, are certainly having their moment. Wherever we look, we see headlines proclaiming the death of active management, and we recall Patton’s statement that:

“If everybody is thinking alike, then somebody isn’t thinking”

In general, the “average” large cap manager, as defined by the passivists, underperforms over almost any time horizon, even five-years! Wow! Who knew that was the longest period one could evaluate in this age of big data. Never mind that we are in the eighth year of a bull market. Clearly that can’t influence the results of these studies. Although, we are reminded of Howard Mark’s admonition to “never confuse brains with a bull market.”

Maybe these passivists are really more end-point dependent in their analysis? Let’s take a look.

"Success is how you bounce on the bottom"We decided to take a look at our bailiwick, small cap value, and see how our peers, as defined by Lipper using net of fees mutual fund data, have done since 1999. We can certainly see that recent results have not been kind to small cap value managers. Looking at rolling one-year periods, the only worse period was 2006, though it seems active

Active Investing is Not Dead, by George!OPUS CAPITAL MANAGEMENT | EXPERIENCED. INDEPENDENT. PROVEN.

2 Active Investing is Not Dead, by George!Opus Capital Management

managers bounced back strongly thereafter.

Rolling three year numbers look much the same, with a strong bounce back after 2006. Interestingly, on a rolling 10-year basis, more than half of managers currently beat the index net of fees, and have done so consistently.

Wait, that can’t be right, can it?

Orwellian Doublethink and the Passivist OrthodoxyThe chorus of voices condemning active management to the dustbin of history has been deafening lately, which reminds us of a quote from another famous George, Orwell in this case:

“Whoever is winning at the moment will always seem to be invincible.”

George Orwell (we know his given name was Eric Blair, but give us some latitude here) made this statement, and it certainly applies to the hubris with which passivists are thumping their chests, and the accompanying sense of resignation from many active managers (and their clients).

Orwell’s magnum opus, 1984, is currently soaring up the best seller list. If we think back to one of Big Brother’s favorite slogans, “Ignorance is strength”, we reveal the passivists view of the world. Essentially, it is better to claim ignorance of knowing how to select asset managers that will provide long-term outperformance and rely on the strength of the index creators and ETF providers to offer you strong returns through a rote process of index construction. The passivists are masters of Orwellian doublethink, simultaneously contending:

• Markets are too efficient for active managers to outperform• Active managers only outperform in down markets

A classic paradox. Are markets less efficient when they are down, or does indexing work only by means of outsized flows into companies deemed part of the index by the party members at S&P, MSCI, or Russell? Best to simply adopt the passivist orthodoxy which, as Orwell stated, “Orthodoxy means not thinking--not needing to think. Orthodoxy is unconsciousness.”

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20%

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% of Active Managers to Beat Benchmark - 1 Year

% Beat 1

% of Active Managers to Beat Benchmark - 1 Year

35%

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70%

% of Active Managers to Beat Benchmark - 3 Year

% Beat 3

% of Active Managers to Beat Benchmark - 3 Year

35%

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65%

% of Active Managers to Beat Benchmark - 5 Year

% Beat 5

% of Active Managers to Beat Benchmark - 5 Year

48%

49%

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54%

55%

56%

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16

% of Active Managers to Beat Benchmark - 10 Year

% Beat 10

% of Active Managers to Beat Benchmark - 10 Year

What happens when we test the orthodoxy? A microcosm of what can happen when things turn against an ETF can be seen from what happens when the inflows stop, or (gasp) outflows occur for an ETF. Unsurprisingly, valuation becomes a matter of company fundamentals, not indiscriminate buying, and those companies not part of the ETF decline by far less. The following example, from FIG Partners, shows what happens when flows into ETFs focused on financials turn negative.

Between October 2016 and March 6, 2017, the dollars invested in an ETF that tracks the KRE Regional Bank Index rose 260% to $4.3 billion. The S&P Financials sector ETF, XLF, rose to $25.6 billion, more than tripling over this time. When both ETFs began to experience outflows in March, those banks not in an ETF declined 2.0%, while those held in ETFs fell 9.3%.

However, when times are good, as they have been for the last eight years, investing alongside the passivists is an easy way to win. Research from Jefferies shows that companies owned by small cap core managers that were in the Russell 2000 outperformed those outside the benchmark in every up quarter during 2016, accumulating an advantage of over 700 bps for the year! To use Orwellian newspeak, stocks held by managers not in the benchmark are ungood. What makes them ungood? Not being in the benchmark, where massive inflows and indiscriminate buying bid them higher.

Words You Can’t Say on Television About Passive InvestingAnother famous George, Carlin in this case, noted “Inside every cynical person, there is a disappointed idealist.” We get the feeling many passivists fall into this camp. Like poor Winston Smith in 1984 or the shell-shocked soldier Patton berated as he marauded through Sicily, many investors have decided it is easier to throw in the towel and ride the passive wave, citing historical returns to confirm their point of view.

We take umbrage with this on two counts. First, as we showed previously, within small cap value, active has historically added value. Second, we acknowledge that the past is only prologue and that the future may be markedly different than the past, while passivists cling dogmatically to the notion that the future will be like the past. As the brilliant (though sadly not named George), Peter Bernstein wrote in Against the Gods: The Remarkable Story of Risk “So we pour in data from the past to fuel the decision-making mechanisms created by our models, be they linear or nonlinear. But therein lies the logician's trap: past data from real life constitute a sequence of events rather than a set of independent observations, which is what the laws of probability demand.[...]It is in those outliers and imperfections that the wildness lurks.”

Having just broken a lengthy streak where volatility has been at unprecedented lows, and in the eighth year of a rampant bull market in the U.S., investors, and especially passivists, are content with what have been acceptable returns on their index portfolios. Who can blame them? So as long as markets go up each and every year, there are no worries. But what happens when they do not?

Carlin also stated, in one of my favorite quotes of all-time, "Think of how stupid the average person is, and realize half of them are stupider than that." If someone can look at this graph, especially when comparing where we are today versus 1999, and think that the next eight years will look like the last eight, George would probably generously call you average.

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R2K Holdings Non-R2K HoldingsQ1 -3.69 -0.82

Q2 4.14 2.92

Q3 11.20 8.09

Q4 9.57 3.96

2016 22.19 14.71

2016 Small Cap Core Manager Performance

-2.0%

-9.3%

Source: FIG Partners Research, SNL Financial LC

Median Price Change Since March 1st

NON ETF

ETF

Don't Get Caught Driving in the Rearview Mirror!As our last George (Soros, in this case), reminds us, “Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.” What is more unexpected than a comeback by active managers?

Aon Hewitt's Meredith Jones notes, "Relying on past performance is like driving to the grocery using nothing but the rearview mirror." Seems like passivists are headed in that direction now!

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About The AuthorAdam T. Eagleston, CFA - Principal and Portfolio Manager @AdamEagleston Mr. Eagleston is a member of the investment team responsible for research and portfolio management for Opus’ Value and Value Plus strategies. Mr. Eagleston has 20 years of investment experience, and prior to joining Opus was vice president and senior portfolio manager for Huntington National Bank. Previously, Mr. Eagleston served as chief investment officer for Pinnacle National Bank’s institutional trust division and for First Mercantile Trust Company. He has also served as an investment analyst for First Mercantile and as a senior research analyst for Carolinas Investment Consulting.

Mr. Eagleston serves on the Investment Sub-Committee for KnowledgeWorks Foundation and is president of the board of Wyoming Youth Services. He is a member of the CFA Institute and the CFA Society of Cincinnati. He graduated summa cum laude from Clemson University with a bachelor’s degree in financial management and a minor in accounting.

About Opus Capital Management Opus Capital Management, based in Cincinnati, Ohio, is a 100% employee-owned registered investment advisory firm specializing in high-quality investments. Opus offers separate account management for public funds, corporations, endowments, foundations, Taft-Hartley and registered investment companies.

Opus' investment solutions leverage decades of experience discovering value in high-quality companies and include:

• Small Cap Value Plus• Microcap Value• International Small Cap• Developed Markets Value Plus• Emerging Markets Value Plus

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Cincinnati, Ohio 45202(513) 621-6787 • www.opusinc.com