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Morningstar Panelists Agree: On Active vs. Passive, It’s Not Either-Or

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Panelists at the third general session Thursday at the Morningstar Investment Conference in Chicago agreed in some areas and disagreed on others, but their consensus argument on the passive versus active management debate is that advisors and their clients shouldn’t think of it as an either-or proposition.

Rather, Rob Lovelace of American Funds, Diana Strindberg of Dodge & Cox and Rob Davis of Vanguard made the case for including both a passive, indexed approach to investing and the actively managed approach in building client portfolios.

“There’s room for many strategies in the market,” Strindberg said, arguing that “we have an approach that works well for the clients we work with, and we stick to it.”

To Dodge & Cox, having an approach is important because “clients can expect [consistency] from us,” she said.

Lovelace pointed out that active management performs better in bear markets, while Strindberg noted that one clear benefit of active management is that it’s less volatile, while by contrast and by definition, “indexing gets all of the downside” of a down market.

Vanguard’s Davis said that $1 trillion of the assets under management at the firm are in active funds, “which might surprise many,” while also pointing out that “passive investing is only starting to peak globally,” lagging passive investing’s prominence in the U.S.

The managers also pointed out some of the confusion surrounding the active vs. passive debate comes from misperceptions on the part of investors. Lovelace said that in conversations he has with advisors, he sees “a lot of the pressure [on going the passive route] comes from fees.” He told an anecdote about a woman he met at a charitable function who, once she heard that he was a portfolio manager, said that while she didn’t know much about investing, she did “know enough to invest only in index funds” because those funds had lower fees. “That simple equation, if it’s indexed, it’s a lower fee,” Lovelace said, is a problem.

Strindberg agreed that the question of fees is “enormously important because mathematically, every lower dollar in fees is another dollar in an investor’s pocket.” However, she also called for a “a definitional moment,” since many investors view active management as “everything that isn’t passive,” despite the fact that 30% of active managers are really following “closet passive” strategies, “except they charge a lot more.” She argued that constructing an actively managed portfolio requires “a lot of careful, intensive research work.”

Moreover, she said that for investors “it’s important to know what you’re paying for: active managers are looking through the windshield to determine what will do well and avoid what will do poorly, rather than looking in the rearview mirror at what did well and what did poorly” and building portfolios based on past performance.

On strategic beta products, Davis said that at Vanguard “we strongly dislike some of the marketing materials” around what he prefers to call “factor-based investing.” Strategic beta can play a “moderate role in the portfolio,” if the investor “believes that the managers taking factor bets are adding value.” However, he warned that investors should realize “you’re going to suffer some down [periods]” if you follow the strategic beta approach. She said that the important question on strategic beta strategies is for the advisor or client to ask “why are you investing in the markets? Is it because the market is not efficient or are there behavioral factors” in play that strategic beta products can use to their advantage? Finally, she said, ask “will they perform better than some other active managers?” When asked by the moderator, Morningstar’s Ben Johnson, what advisors could do to improve the “probabilities” of choosing effective, alpha-producing active managers, Lovelace said there were “three key steps to find that select group of active managers.”

First, he said, is that “fees matter,” so look for managers whose fees are in the lower quartile. Second, look at the manager’s track record. “The longer the better,” Lovelace urged, and pay special attention to the manager’s “downside capture.” Third, look for funds whose managers invest in their own funds, on both the individual fund level and on the fund family level.

Following these steps, Lovelace said, can help advisor find managers “who can deliver 100 basis points of alpha a year.”

Davis added that advisors should watch out for closet indexers, and also lauded those managers who closed their funds to new investors at “times of big cash flows. That exhibits strong stewardship.”

Strindberg had the last word, arguing that advisors should look for active managers with long investment horizons and who exhibit low turnover, “a manager with convictions.”

Looking ahead, Davis said that he expects ETFs to “explode in the next few years, but then there will be an ETF “thinning of the herd” as has been seen in mutual funds. “Alpha exists,” he said, “and there will always be a premium paid for it.”

Lovelance said that “active has been pushed to edge with passive at the core,” but American Funds believes that “active should be at the core,” especially for clients in or near retirement, because of active’s lower volatility.

— Check out Who Wins ‘Passive vs. Active’ Institutional Debate? Pt. 3: U.S. Large Cap Value on ThinkAdvisor.