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The Active-Passive Spectrum

Think in terms of continuity rather than conflict.

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Conflict tends to be the norm in discussions about active and passive investing approaches, but it shouldn't be. While a March 2019 article in The Wall Street Journal reinforces the idea that "few rifts in the world of mutual funds are as pronounced," [1] active and passive approaches exist as points along a continuum. Thinking about where individual strategies and portfolios fall on that scale rather than how they oppose each other is a more constructive way of evaluating investments.

At their core, passive strategies are rules-based approaches that aim to reproduce the results of a given market, while active strategies incorporate--to varying degrees--qualitative judgments about the ability of an investment to outperform that market. To grasp the passive-active continuum, it is helpful to distinguish between at least five different types of strategies, ranging from the most passive to genuinely active.

The Index End
On the passive-most end of the spectrum are market-cap-weighted index or exchange-traded funds that track the broad market--think Vanguard 500 Index (VFINX), which replicates the S&P 500 and receives a Morningstar Analyst Rating of Gold. These strategies have proved effective because gross of fees they reproduce the aggregate return of the stocks in their broad-market benchmarks. A return that is average before fees becomes above average after fees because index funds typically charge much less than their actively managed counterparts.

Trading Tools
Market-cap-weighted strategies tracking narrow market segments rather than the whole are a step toward active. Opting for a certain sector is an implicit bet on its superiority to the broad market and other sectors. If, for example, you invested in a market-cap-weighted energy sector index fund at year-end 2014 because you thought the price of oil could not fall much further, your index fund would have lagged the broader market by a lot because energy stocks have performed poorly. Vanguard Energy Index (VENAX) lost 15.35% cumulatively between January 2015 and July 2019, versus a 59% cumulative gain for the S&P 500 during the same time.

Non-market-cap-weighted, rules-based approaches come next. Morningstar calls them "strategic beta" strategies, and Franklin Templeton's LibertyQ ETFs, launched in June 2016, are good examples. They're passive in that they track benchmarks, but active because factor-based security-selection models, rather than market cap, build those benchmarks. These customized benchmarks, in turn, are supposed to beat, not just replicate, targeted market segments on a risk-adjusted basis.

That's easier said than done, and sometimes such strategies prove far from strategic. Franklin LibertyQ Emerging Markets ETF's (FLQE) 23.83% cumulative gain from its June 2016 launch through July 2019 lagged the MSCI Emerging Markets Index by 15.4 percentage points and fell short on risk-adjusted metrics, too.

The Pretenders
Then there are funds that tend to be active in name only. Often called "closet index" funds, they claim to seek benchmark-beating results, but their investments don't differ much from the benchmarks they're trying to beat. In practice, their before-fee returns are never far from their benchmarks', but their after-fee results fall short. Neutral-rated Eaton Vance Tax-Managed Growth 1.2 (EXTGX) carries a Negative Process rating because it is one such pretender. Its holdings' overlap with the S&P 500 is considerable, and since the current management team formed in March 2008, its 8.7% annualized return through July 2019 lagged the S&P 500 by nearly 1 percentage point, which closely aligns with its average expense ratio during that time. Index funds and ETFs are just as and sometimes more tax-efficient.

The Real Deal
Finally come genuinely active funds. They vary from diversified security selectors, such as Gold-rated T. Rowe Price Blue Chip Growth's (TRBCX) Larry Puglia, to managers who take more idiosyncratic risk, such as Silver-rated Alger Small Cap Focus' (AOFAX) Amy Zhang. The best genuinely active funds deliver long-term outperformance after fees, but the challenge is picking them in advance of that outperformance and holding on to them during the inevitable periods when they look out of step with their benchmarks (precisely because they must differ from their benchmarks to beat them).

Both-And, Not Either-Or
There are legitimate as well as illegitimate ways to construct passive and active portfolios, or a blend of both. Trying to trade among sector-specific ETFs based on which one might outperform next quarter is questionable, at best. Relying on an index fund for efficiently priced U.S. large-cap equities and a carefully selected active manager for exposure to more inefficient areas, such as, emerging markets, makes sense.

The framework presented here isn't comprehensive. One could expand it to include quantitative strategies as well as distinctions between high-conviction, concentrated active strategies and multimanager approaches, which at their best are a blend of high-conviction, concentrated approaches. The important point, though, is to evaluate active and passive strategies and portfolios in terms of continuum, not conflict.

[1] "Is Now the Time for Active Investing to Make a Comeback?" The Wall Street Journal. March 17, 2019.

Alec Lucas has a position in the following securities mentioned above: AOFAX. Find out about Morningstar’s editorial policies.