Active vs. Passive Funds

THE ACTIVE VERSUS PASSIVE DEBATE HAS BEEN WITH US FOR SOME TIME. GENERALLY, PROPONENTS OF ACTIVE MANAGEMENT ARE LOOKING TO “BEAT THE MARKET”

For several years during our recent raging bull market, the average passively managed fund has outperformed the average actively managed fund.

Morningstar contends that “passive investing is now the mainstream approach,” with nearly $2 flowing into passive investments for every $1 flowing into active investments.² Of course, past performance may not be indicative of future performance however, there is a strong case to be made for investors and plan fiduciaries to offer participants access to an array of index funds covering major core asset classes. Fees, market coverage and tracking error are key considerations in the selection process.

The growth in passive investment utilization has been significant. In 2004, there were only 150 exchange-traded funds (ETFs)—by 2014, there were 1,300.³ Morningstar indicates that asset flows to actively managed funds was 2 percent in 2014, compared to an 11 percent organic growth of flows to passive investment portfolios.⁴

While recent history has favored passive funds, active funds have had long stretches of outperformance, furthermore, relative performance of active versus passive funds runs in cycles. Historically, managers generally appear to excel when stock picking or defensive positioning is called for. Periods of rising interest rates have shown outperformance by active managers.5 While few active managers outperformed their index in 2014, long- term numbers are better with about 45 percent of active managers outperforming their index over the span of 10 years ending in 2013. Indices are generally market-cap weighted (the larger companies have a bigger weighting than smaller companies), therefore, passive funds can be skewed toward the larger stocks.²

It is important to note that during periods in which passively managed funds are said to be outperforming actively managed funds, they are typically referring to the average active manager⁶. In our scoring system, the average active manager scores a 6—this is typically not a fund our methodology would identify as a replacement/selection option.

Our approach in selecting actively managed funds is to identify funds where the manager has exhibited skill over various market conditions. Identifying manager skill is the main goal of the Scorecard Methodology™. To monitor investments, we have selected analytics that work well together to enable us to truly identify manager skill—as opposed to managers that might get “lucky”, or those who might generate good returns while operating outside the comfort level of some prudent ERISA fiduciaries. We are less concerned with the averages and more concerned with a manager’s ability to measure against an appropriate benchmark, which is a better measure of skill.

Investors looking to reduce market risk may also wish to consider active managers whose performance analytics reflect lower market volatility (e.g. standard deviation, down market capture, less correlated to market/peer group). Market risk is inherent in passive management—if it increases, the risk for your passive funds increase along with it. We believe some sectors are inherently less efficient making it possible for active managers to outperform their passive counterparts.

We believe there is an opportunity for both active and passive investments in a well-designed portfolio. We call this a “core-satellite” approach—where passive management serves as the “core” of the portfolio comprising of half or more of the portfolio’s allocation and active management serves as the “satellite” which comprises of the remainder of the portfolio’s allocation. While the “core” keeps the allocation intact and tracking, the “satellite” portion provides incremental return opportunities and risk control through a combination of out-of- benchmark weights and skillful active management. As the passive versus active debate continues, and as one philosophy dominates the other over the short term, it may be more beneficial to determine how they best fit together to optimize the real long-term opportunities.

With active funds, the fund manager attempts to add value and outperform for that style of investing. Typically, these investment strategies have higher associated costs due to the active involvement in the portfolio management process by the fund manager(s). With passive funds, the fund manager attempts to track or replicate some area of the market. These types of strategies may be broad-based in nature (e.g., the fund manager may be trying to track/replicate the technology sector). These investment strategies typically have lower costs than active investment strategies due to their passive nature of investing and are commonly referred to as index funds.

Rekenthaler, John. “Do Active Funds Have a Future?” Morningstar.com. August 6, 2014. http://news.morningstar.com/articlenet/article.aspx?id=659902

Karabell, Zachary. “Solving the Active Vs. Passive Investing Debate,” Barrons.com. January 26, 2015. http://online.barrons.com/articles/solving-the- active-vs-passive-investing-debate-1422304950

http://www.financial-planning.com/gallery/fp/active-vs-passive-fund-flows-for-2014-2690725-1.html

Max, Sarah. “Return of the Stockpickers; Active managers are likely to recapture their lost glory as interest rates rise,” Barron’s, January 23, 2015. http://online.barrons.com/articles/return-of-the-mutual-fund-stockpickers-1420870199

Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. The opposite of active management is passive management, better known as “indexing.”