Active and Passive Branch Out

The rise of passive investing has clearly been one of the dominant investment stories of the past few decades. But while indexing has won investors' minds, our hearts still yearn for active. It's the age-old battle between philosophy and poetry played out in a modern investment setting. Reason tells us that buying and holding the whole market at the lowest possible cost and maximum tax efficiency is the virtuous path. Our emotions suggest we can do even better if we deviate here and there, slice up the market into smaller bits, tilt the portfolio to current trends, or even play a hunch every once in a while. The velocity of money in index funds, particularly index ETFs, suggests that long-term reason is frequently overruled by short-term passion.

The desire to tinker, to add action even to passive, is seen in the ongoing division of investment offerings. The split between active and passive has been followed by mutations toward greater activity in each of these categories. Strategic beta has evolved as a more active version of beta, and alternative investing has risen as a more dexterous form of active management. We now live in a four-bucket investment world: beta, strategic beta, active, and alternative. That three of the four buckets are nonpassive reflects our poetic, emotional side. Still, reason has its say in all four buckets; costs and tax efficiency are a standard to which offerings in each bucket are held. Even if you've never put a penny in index funds, you benefit from the increased attention they bring to these variables.

Let's review the state of these four broad approaches.

To be competitive in the beta space, costs must be under 25 basis points and tax efficiency must be extremely high. While hundreds of expensive and high-turnover index funds still exist, they hold relatively little assets. Money flows almost exclusively to the least-expensive, most tax-efficient offerings. Vanguard is the clear leader in the beta bucket, but iShares, Schwab, and others provide very credible competition. Investors have many great choices here.

Strategic beta holds great promise as an investment option, but fees must trend toward or below 50 basis points and tax efficiency must be high. New players like Research Affiliates and WisdomTree are showing that legitimate, long-term investment vehicles can be crafted here. In time, active-management shops and even beta purists are likely to join the mix, making this an area of great future expansion for the investment industry and a source of many great future offerings for investors. (Traditional beta players, such as Vanguard or Standard & Poor's, avoid the category more for political, rather than investment, reasons. In time, they too will likely join the party.)

The retilting of the playing field toward passive means most active funds continue to suffer steady outflows, but the active approach isn't going away. To be competitive here, expenses will need to dip toward or below 75 basis points (the less costly offerings already gather almost all of the flows) and tax efficiency must improve considerably. Active U.S. fund managers are particularly disadvantaged relative to passive funds. The United States is one of only four fund markets in the world that taxes capital gains realized internally in the fund, rather than taxing only distributions withdrawn from the fund. This archaic legislation significantly favors beta and strategic beta over active and needs to be changed if active is to thrive outside tax-sheltered plans.

Alternatives generate a massive amount of press, but to date, they have demonstrated limited benefits for investors. Yes, there is a clear theoretical benefit from an uncorrelated asset class and the potential to limit losses in a bear market, but so far, that benefit has been dwarfed by high fees, poor tax efficiency, and very poor use by investors, who buy these funds at market bottoms and abandon them at peaks. A recent pitch from one of the better alternative shops demonstrates the issue. The firm brought in a noted academic to develop a strategy that backtests brilliantly, adding on average 150 basis points per year over the broad market. The problem? The fund's expense ratio is 1.5%, and its high turnover makes it tax-inefficient, leaving investors if all works right with an index-like result minus a big tax bill. To be competitive, alternatives funds must bring their costs below 100 basis points. But few alternative managers currently will work for that fee, so this remains a generally unattractive bucket for investors--although efforts of some firms and Vanguard's tinkering with the category suggest change may happen in time.

Extremists will continue to argue for pure beta or tout exclusively the benefits of alternatives. But no one is forced to pursue only one of the extremes. The extremists on both sides of the active/passive debate, while making for entertaining theater, do more to hinder than advance the discussion. The sad reality is that too few people invest today. How they choose to invest is a secondary issue. There is no morally superior way to save for your future. The only shameful act is not to try to save.

The current negativity expressed by the bomb-throwers on both sides of the active/passive debate obscure the most salient fact: Today's investors and advisors have a terrific range of credible choices. There's no reason to ban the poets from the city. Investment success can tap both our hearts and our minds. If a combination of active and passive approaches makes an investor more likely to save or gives an advisor a more compelling case to keep the client on course, it's a win. And when investors win, we all win.

This article originally appeared in the August/September 2015 issue of Morningstar magazine.