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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.

There's a common example that helps illustrate this tendency. A university professor who asks each of his students whether they are a below-average, average, or above-average drivers will find that roughly 90% of the students think they are above-average drivers. This, of course, is a statistical impossibility. Similarly, most investors believe they will "beat the market," even though few actually will.

Along with excessive confidence, there is also an element of hope involved when it comes to investing. In fact, Avi Nachmany, founder of Strategic Insight, notes, "The investment business is, by definition, a business of hope. Everyone hopes that he can beat the market, even if few people actually can."

Active or Passive? Both
Unfortunately, the active versus passive or ETF versus mutual fund debates tend to be polarizing. But these are not all-or-nothing proposals. Investors can benefit from keeping an open mind.

In my opinion, a more productive debate would be deciding how much of your optimal portfolio should be in active or passive investments, or which asset classes have the greatest potential for alpha and should therefore be accessed through active management.

After making the philosophical decision to go active or passive in a given market segment, the debate should evolve to whether an ETF or mutual fund (or another investment vehicle) is the best solution for that portion of your portfolio.

In Good Company
A major trend among institutional investors in the last several years has been what many describe as the "marriage of alpha and beta." Most commonly, this refers to an investment strategy that employs passive investments to get core beta exposure at the lowest possible cost. Recognizing how elusive alpha is in large heavily trafficked markets, many professional investors will target asset classes like domestic large caps via low-cost passive investments.

With the remaining satellite portion of the portfolio, many institutional investors will look to access smaller, less liquid markets by tapping into the expertise of an active manager. Active management makes the most sense in markets where the institution believes it (or the portfolio manager it plans to hire) has an "edge," or informational advantage.

Investors would do well by keeping their confidence in check. If you don't have an edge, keep costs low and get passive market exposure. Focus your time and efforts on the areas of the market where alpha is more abundant and likely to outweigh the higher costs of active management.

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

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