Morningstar - Q3 2020 - 19

managers' benchmarks, making small-cap passive
products a more reasonable focus.
The Russell 2000 Index-the most commonly
used style-neutral small-cap index-has tripled
in size since the December 2000 start of
this study. To account for that, flows into passive
vehicles were scaled based on the Russell
2000's market cap at that time; for example,
$1 billion of inflows into passive products
in 2000 represents a larger influx than $1 billion
of inflows in 2020.
Because flows into passive small-cap strategies
deviate widely month to month, this study
looks at 12-month rolling sums. It compares the
returns of the oldest share class of actively
managed strategies with the Russell 2000 over
the preceding 12 months to proxy the success
of active managers.
A time series of the data shows a few periods
that support the idea that passive flows adversely
affect active manager performance. In the
year preceding December 2005, more than 70%
of active strategies outperformed the Russell
2000 amid weaker flows into passives. Over that
time, the Russell 2000 rose only 2.5%, perhaps
an indication that managers were able to

skillfully select the best stocks in an otherwise
sleepy market. August 2019 saw 60% of
managers outperform over the trailing 12 months,
while ETF flows fell to several-year lows and
the Russell 2000 dropped 15%. Many examples
can be found by checking through the data
month by month.

It's difficult to conclude that active managers
meaningfully suffer from flows to passive
products based on this data. While a few periods
might lend credence to the idea, just as many
contradict it, indicating that passive flows
don't have a direct impact on active manager
performance. Stock-picking is a gargantuan task,
but flows into passives don't seem to directly
make it more challenging.

However, several periods also saw poor active
manager performance even with weak flows
into passive products, or vice versa. The
year preceding July 2008 saw low flows into
passive products but also poor active manager
performance, even in the type of volatile
equity environment that many managers claim
helps them. The year preceding August 2012
saw only 34% of active managers outperform
the Russell 2000, while 12-month passive flows
were negative.

Nicholas Goralka is a manager research analyst
for Morningstar.

Auto Demand Hits
Pothole
Global light-vehicle demand has hit a deep
coronavirus pothole. The extensive damage requires
a lengthy repair, and we expect global demand
to reach more normal levels in 2023. However, we
do not believe the damage is structural.

Meanwhile, heavy inflows into passive products
haven't always been a death knell for active
managers by any means. For example, the year
before August 2009 saw 61% of active managers
outperform despite strong flows to passive
products, and the year before January 2016 saw
more than 65% of active managers outperform
the Russell 2000 over the preceding 12 months
amid sizable passive inflows.

Before the pandemic, we had forecast world
light-vehicle demand to be up 1% to down
2% in 2020. Barring another wave of the pandemic
that shuts down global vehicle production
and closes dealerships again, we now expect 2020
global light-vehicle demand to be down 17%
to 23%. We set a wider-than-normal band around
our updated demand forecast to reflect greater
uncertainty from the coronavirus impact.

Passive Flows vs. Active Performance The evidence suggests there is no
causal relationship.
12-Month Flows Into Passive Small-Cap Funds,
Scaled for Russell 2000 Market Cap

Percentage of Active Managers Outperforming
Russell 2000 Over Previous 12 Months

$8B

80

6

60

4

40
40

2
0.49

0
-2

20
0

12/2000
Source: Morningstar.

12/2005

12/2010

05/2020

There are risks to our new forecast in addition to
another wave of the pandemic: Our optimistic
China forecast for a solid recovery in the second
half of 2020 may not materialize; the duration
and severity of the U.S. recession may be worse
than we expect; and second-half 2020 demand
in Europe might be further adversely affected by
Brexit and U.S. trade conflict.
That said, for patient, long-term investors, we view
the coronavirus crisis as an opportunity to own
select auto stocks at heavy discounts. While our
top picks were up significantly from their March
lows at the end of the second quarter, we still
think BMW BMW:DE, GM GM, and BorgWarner
BWA have substantial upside.

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