Where Active Management Is Headed

Funeral March In Tuesday's article "The Dying Business of Picking Stocks," The Wall Street Journal all but buried active stock management. According to the Journal, the great mutual fund battle is over. The index funds have won, leaving actively managed funds reeling for the foreseeable future.

That is correct. The reasons are many. Logic supports low-cost indexing (higher-cost indexing is another matter) because the average investor is by definition average, which means that cheaper investments are by definition above average. The numbers support it. So, increasingly, do legal pressures--401(k) plan sponsors in particular are becoming conformist. No wonder, then, that index funds now account for more than 100% of the industry's net sales.

Active management has three credible responses, each of which is already occurring, to various degrees. As more active managers face reality--an understandably slow process, given how long that active management reigned, and the delightful profitability of that business--these three trends will accelerate to the point where they become dominant. Few of today's actively managed funds will survive in their current forms.

Discount Goods

One tactic is to become a discounter--sell active management at only a modest premium over index fund prices, rather than today's markups of 500% to 1,000%. Nobody is doing that today. Yes, Vanguard's actively run stock funds are much cheaper than most in the industry, but they still cost several times as much as their index funds. For example, the Admiral share class of actively managed

That 24-basis-point gap in expense ratios might not seem like much. Historically, it wouldn't have been perceived as being important. But again, times have changed. These days, index funds compete among each other for the tiniest of advantages. A few basis points can make the difference between a best-seller and an also-ran. So, certainly, can a full one-quarter percent. Remove that amount, and instead of lagging their sibling index funds over the trailing decade, in aggregate, Vanguard's actively run U.S. stock funds would have placed (ever so slightly) ahead.

Discounting is a difficult road, and unlikely to be sufficient, in and of itself. Only large funds will be able to cut costs enough to get within sight of their indexed rivals. Perhaps the expense cuts will be enough to push those active funds past their benchmarks--perhaps. But even then, the active funds will be less tax-efficient and transparent, and more prone to unpleasant surprises. (They will also give more happy surprises, but typically the pain from the bad news outweighs the pleasure of the good news.)

Thus, discounting will not often be a fund company's sole strategy. It will, however, by a necessary component for nearly all actively managed firms. The current expense difference between the better index funds and the typical active stock fund is too large. Much too large.

Rifles, Not Shotguns The second path is to forego stock-picking. The fashionable, jargon-laden term for this approach is "targeted strategic beta." I will restate this idea in English. Researching individual companies is time-consuming, and therefore costly. The job has traditionally been active management's--but with little success. A handful of fund families have fared well at the task. The rest have had sporadic results, at best.

So, why bother? Redefine active management. Make it not about stock selection, which extracts much sweat and yields little returns. Make it instead about portfolio formation. Run mutual funds that invest in baskets of stocks--securities that share common attributes. As with traditional actively run funds, these baskets could--and most likely would--perform very differently than their benchmarks. But they could be assembled at less cost than what active managers now must spend.

If this seems to you like what the more specialized ETFs do, your instincts are correct: It is like what the more specialized ETFs do. However, such funds are more conservative than what I envision. Their portfolios tend to be very diverse and widely constructed. For example, they might emulate a general U.S. value-style index. My suggestion is for the rifle, not the shotgun. Buy relatively few stocks (say, three dozen) that occupy a small corner of the stock market. By all means, be cost-effectively active, but be active. Don't go halfway.

Devising Solutions Finally, actively managed funds can offer solutions, not just asset classes. Index funds give market exposures--participation in investment arenas. That is fine for those who wish to build their portfolios fund by fund, brick by brick, with close control over the inputs. Indeed, because index funds have greater transparency than actively run funds and do not "drift" in style, they are the easiest funds to use for such strategies.

However, not all investors, on all occasions, will wish to take such an approach. Sometimes, rather than create an asset allocation and fill those slots with funds that are defined by their assets, investors will prefer a fund that does the work for them. Those are solution funds--examples being target-date funds, managed-payout funds, global-allocation funds, and targeted-income funds.

Such funds are actively managed. They may well contain index components, as with several of the target-date families, but the pieces are assembled and monitored through active decisions. A pure-index provider cannot offer solution funds; the very act of creating the solution is an act of active investment management.

Summary Fifteen years ago, fund companies promulgated the notion of "core and explore." Core funds were those from mainstream asset classes, such as U.S. large-company stocks or investment-grade bonds. They were to form the bulk of the portfolio. Surrounding them would be the riskier explore funds, which held more-esoteric investments. They were smaller morsels, for specialized use only.

The terminology remains, but the meaning is rapidly shifting. Today, core funds increasingly refer to index funds, with explore funds being their actively managed rivals. That change means big problems for traditional active-management investment firms. But it also presents opportunities for those that are adaptable. Active managers that trim their costs and meet investors' "explore" needs by creating more-specialized funds, as well as those that give solutions for investors who desire such assistance, should be well positioned for the future.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.