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A Fine Line in the Active Versus Passive Debate

An increasing number of investors are actively using beta in their attempt to create alpha.

John Gabriel, 03/14/2012

With the growing popularity of exchange-traded funds, and passive products in general, many industry observers have speculated on the demise of active portfolio management. However, I would argue that, in reality, active management remains as alive as ever.

Rather than outsourcing active management, many investors are taking matters into their own hands. Using products like ETFs to underweight or overweight certain market segments (beta) in an effort to achieve relative outperformance (alpha) is one of the more-pronounced trends in the industry today.

Although the products themselves are passively managed, they are being used tactically in an active manner by investors seeking to execute certain objectives--whether it be income, capital preservation, or even to outperform the market. Passive investments have dominated recent fund flows in North America. Strong demand has driven the share of passive assets, as a percentage of total fund industry assets, to rise steadily to more than 20% today from about 2% in 1995 (ETFs represent roughly half of total passive assets).

On the surface, it would seem that investors are migrating toward passive strategies. Indeed, there are many investors who believe in efficient markets and favor low-cost indexing as the strategy of choice. However, that doesn't tell the whole story.

The reality is that ETFs are tools that advisors and investment managers use to make active tactical bets. These bets can be anything from sector rotation strategies to underweighting the financials sector or boosting a portfolio's exposure to emerging markets.

While data may appear to suggest the demise of active management, what I really see happening is more investors actively managing passive products. Consider that on any given day ETFs represent 30% to 40% of overall trading volume on the New York Stock Exchange. Not exactly the type of activity one would expect from passive investors.

The Death of Active Management Has Been Greatly Exaggerated
As long as a chance for outperformance exists, active management will have prominence in the investment industry. Human characteristics ensure active management in the investment industry is here to stay.

Numerous studies have examined the role that cognitive behavior, or human nature, plays in the investment selection process. The universal conclusion is that investors tend to be overconfident in their ability to select winning stocks or funds.

John Gabriel is an ETF strategist with Morningstar and contributor to Morningstar ETFInvestor. Click here for a free issue.

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