Active/Passive Is Not Either/Or

This analyst blog is part of our coverage of the 2015 Morningstar Investment Conference.

Active managers have been derided in the financial media in recent years for failing to beat their benchmarks. But it's not just headlines; investor dollars continue to flow away from active strategies and into passive ones. This has led many industry observers and pundits to ponder whether this trend away from active strategies and toward passive strategies is here to stay, and to question what the future holds for active management. This has become known as the "active-passive debate."

Three industry experts shed some light on this question at the 27th annual Morningstar Investment Conference in Chicago Wednesday night. The panel featured insights from Joe Davis, global head of the Vanguard Strategy Group and Vanguard's global chief economist; Rob Lovelace, portfolio manager and president of Capital Research and Management Co; and Diana Strandberg, portfolio manager and director of international equity at Dodge & Cox. The discussion was moderated by Morningstar's director of global ETF research, Ben Johnson.

Active Strategies Still Have a Role in a Portfolio As the discussion began, the panel asked the audience members for a show of hands indicating whether they used both active and passive strategies in managing their own or client portfolios. When the informal poll showed that the majority in attendance did use a combination of strategies, it nicely illustrated a concept on which all three panelists agreed: The "active-passive debate" hinges on a flawed premise. Rather, investing should be objective-based; it doesn't necessarily require that an investor choose passive strategies to the exclusion of active ones. The more important point is how the strategies can work together to get investors to their goal.

Lovelace noted that controlling downside risk is one argument in favor of using active strategies in a portfolio. There is a prevailing focus on fees and a perception that using passive funds will lower the overall fee in the mix. But there are active funds that have better returns and lower volatility and also charge low fees.

Strandberg added that regardless of whether you're in an active or a passive vehicle, you own a portfolio. That portfolio in a passive vehicle is not constructed with the goal of trying to preserve capital and earn a real return, she said. It's constructed "looking in the rear-view mirror," by owning more of what did well, and less of what did poorly. Active managers, in contrast, are trying to "look through the windshield" at what will do well and avoid what will do poorly (though she concedes that sometimes they get it wrong). "It's a very different emphasis, but I would like to underscore that regardless of whether you're in passive or active, you're in a portfolio that is constructed by somebody. And I think it's important to understand what you're paying for."

Further, Strandberg made the point that there is room for a lot of different strategies and approaches, and in particular there is a lot of room for skilled active management--and there is a cohort of managers that has added demonstrable value.

So How Does One Find an Active Manager Who Is Likely to Add Value? Rob Lovelace shared what, in his view, are the three key steps that he would recommend to identify active managers that are likely to add value. The first consideration is fees, which have a big impact over time. Look for fees in the lower quartile. Also, look at the managers' track records, with a particular focus on downside capture. Look for managers who do better in down markets, because it's the volatility dampening that's critical. And the third criterion, according to Lovelace, is to look for managers who invest significantly in their own funds. If you combine those three, you can come up with a list of managers that will consistently, over time, produce those superior results with lower volatility.

Question Myths and Perceived Truths Davis added that it's prudent not to focus on things that don't matter as much or aren't as statistically significant in identifying managers who outperform. He points to active share, a metric that has gained a lot of attention in recent years, for example. "The more active share you have certainly guarantees higher tracking error, it just doesn't necessarily guarantee that tracking error is positive."

He also questioned the broad myth that active management only makes sense in some markets that are perceived to be inefficient, such as the small-cap space or in the high-yield space or in the emerging-markets space. "Talent and skills exist in all of those markets," he said. Look for processes that are repeatable and transparent, and pay attention to the research and ethos at the firm. Other things to look for is whether fund companies close their funds to new investment in times of strong cash flow. "I think that's an incredible sign of stewardship," he said.