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Question of the Week - July 27, 2015

Question of the Week - July 27, 2015

Guest Post - Monday, July 27, 2015

What's the status of the active vs. passive debate these days?

Unsurprisingly, the answer is-it depends. In a competition between an active fund portfolio or a passive ETF strategy, the winner/loser seems to change every year, which fuels the ongoing debate many advisors have about which is the better approach.

Several years ago, the debate was simple: you had the choice of actively managed mutual funds or passive funds that tracked very broad market indexes of some sort (some providers charging lower prices for this service than others). That was it. Typically, you could index more expansive portions of the U.S. equity markets, such as large-, mid- and small-cap, as well as very generic foreign developed and emerging market indexes. For the most part, fixed income indexing was generally limited to the BarCap Aggregate bond index and maybe a handful of other one-offs.

Enter the world of exchange-traded funds a few years ago. Starting with a few hundred offerings with similar broad exposure to what index funds already provided (they basically were and many still are forms of index funds), ETFs now number in the thousands, with a myriad of exposures targeted to specific countries, sectors, sub-sectors, methods of calculating stock indexes (e.g. 'smart beta') and other 'themes' in every flavor from sky-high dividends to global water resources. Bond ETFs have also evolved, perhaps even more dramatically, into segmented sleeves of distinct maturity and credit exposure, and individual nation sovereign debt, sometimes in both local and USD terms. Other products offer exposure to individual commodities, volatility futures themselves, not to mention the variety of two times- and three times-levered exposures intended for specific exposures and holding periods. The ETF group has truly evolved.

This has made life difficult for many active funds. Active funds rely somewhat on 'trust,' meaning a track record of meaningful risk-adjusted performance, or a process/philosophy in place that offers either a probability that good returns or a reduction in risk can occur. Instead of being the only game in town for retail investors like they once were, many middling managers or those unable to otherwise distinguish themselves from peers languish under an increasingly focused microscope where fees are being scrutinized and funds are being forced to defend their bang-for-the-buck.

The easy story is that ETFs are generally cheaper than funds—often expense ratios for larger ETF strategies are quoted at a fraction of the price of active management. After acknowledging a academic articles reiterating that the 'average' mutual fund manager out there will likely trail their benchmark by the amount of their implied fee (we don't dispute this finding, noting that many generic 'C share' offerings and funds of all shapes and sizes are included in this mix), this may seem like a slam dunk, but there's more to it. 'Average' can be a deceiving term. As of last week, 1,760 ETFs and 8,050 distinct mutual funds are being marketed today; you're bound to see a wide variety of winners and losers. For many years, the number of mutual funds has rivaled the size of the publicly-traded equity universe (including pink sheets), which in itself is an odd thing.

The answer comes back to basics: philosophy and probabilities. Some asset classes have shown higher amounts of 'efficiency' than others. For example, many of us would agree (as would many fund managers themselves, even if only privately) that segments such as U.S. large cap, investment-grade fixed income, U.S. real estate and a few others, are heavily-researched, are considered more 'efficient,' for lack of a better word, and, consequently, can offer a more difficult road to achieving outperformance 'alpha.' Note we didn't say impossible, just more difficult, and this tends to be a time-period-dependent analysis.

On the other hand, there are areas where the probability of success using active management appears to be higher. These include markets that are more inefficient, and where careful security selection by quality, valuation or other factors has been productive. A rough lists includes U.S. small cap equities, as well as foreign stocks and bonds. In other groups, active management is worth considering from a risk-reward standpoint—municipal debt and bank loans come to mind, due to the extreme credit-sensitivity of these markets where research can mean the difference between default (and large if not complete capital losses) and not (and even gains from mis-valuations in bonds).

On a time-period dependent level, there also appear to be periods when active and passive move through streaks of outperformance and underperformance. For a quick example, the graphic below depicts the tendency of the large-cap group for a recent decade.

Source: Fidelity Investments

This is a complex conversation with few absolutes, and it can end up as a more complicated story for clients who are bombarded with ETF advertisements claiming rock-bottom fees and easy market access. These, of course, don't include spreads and other trading costs, as well as what a client might be gaining or losing by making the active or passive call. Only being armed with complete information can a constructive conversation be had and the most effective client decision made.

Additional Reading

Read our Weekly Review for July 27, 2015.

Read the previous Question of the Week for July 6, 2015.

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