While the active vs. passive debate has raged for decades, the current bull market has many convinced that all passive portfolios can declare victory. But a closer look at the limitations of many passive strategies – in particular the market-capitalization weighting strategy most employ – reveals the debate is far from over.

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Exhibit 1: Percent of Active Managers Outperforming Their Benchmark by Morningstar Category -- OppenheimerFunds

Three Flaws That Could Potentially Afflict Market Indices                 

1. The index may not be focused on fundamentals

The S&P 500 Index has underperformed – and potentially carried more risk than – Smart Beta approaches that weight securities by a company fundamental or simply by equal weight.

2. The index may not be as diversified as you think

Diversification? Actually, financials and smokestack companies dominate international equity, and state-owned enterprises are prominent in emerging markets equity.

Exhibit 2: Sector Weightings for the MSCI ACWI ex-U.S. Index -- OppenheimerFunds

3. Some indices don’t screen for profitability

The traditional U.S. small-cap index actually has a high percentage of unprofitable companies.

Exhibit 3: Companies in the Russell 2000 Index with Zero or Negative Earnings -- OppenheimerFunds

Three Reasons Why the Active vs. Passive Dynamic Could Change

1. The policies that drove the last 10 years are gone

Quantitative easing and zero interest rates, which propelled passive out-performance, are no longer present across most global markets today.

Exhibit 4: Companies in the Russell 2000 Index with Zero or Negative Revenue (EPS) -- OppenheimerFunds

2. Valuations are rich, particularly in U.S. equities

The index may not be cheap in every sense. While index strategies often have low management fees, the valuations of the underlying securities matter too – and U.S. large-cap stocks are particularly expensive now.

Exhibit 5: S&P 500 Hypothetical Ranking in Large Blend Category -- OppenheimerFunds

3. Correlations between U.S. stocks and the index are lower

After the financial crisis, most companies traded in unison with the broad market, but correlations between individual companies and the broad index have been falling, and that has made stock picking more valuable.

Exhibit 6 -- OppenheimerFunds

Correlation expresses the strength of relationship between distributions of returns between two data series. Correlation is always between +1 and -1, with a correlation of +1 expressing a perfect correlation, meaning that the two series being compared behave exactly the same, a correlation of -1 meaning the two series behave exactly the opposite and a correlation of zero meaning movements between the two series are random.

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