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Active vs. Passive? No Longer an Either/Or Choice for Advisors

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The choice between active and passive investment management is not an either/or proposition because the lines between active and passive are blurring.

In addition to smart beta ETFs, which impose an active management-type filter over passive index investing, such as an equal weighting of index components, there’s also the actively managed mutual fund that owns index ETFs.

“The lines are being drawn between those that favor ETFs or mutual funds, but less is understood that some mutual funds own ETFs,” says Todd Rosenbluth, director of ETF and Mutual Fund Research at CFRA.

Marketfield Fund (MFADX), a global macro fund with about $1 billion in assets, for example, had 19% of its assets in ETFS at the end of the first half, according to a new report from CFRA Research, which recently acquired the equity and fund research business of S&P.

The ETFs Marketfield owned at the end of the first half included single country funds – for South Korea, Mexico and China – and sector-specific U.S. funds for regional banks and home construction-related companies.

Fidelity New Markets Income Fund (FNMIX), a $5 billion emerging markets debt fund, had a 6% stake in ETFs at the end of June, according to the CFRA report. Its ETF holdings include single country equity funds  for Brazil and China and diversified iShares MSCI Emerging Markets stock fund.

The inclusion of these ETFs in mutual funds does more than increase diversity. They also “provide all investors with low-cost exposure to an investment style,” says Rosenbluth. Single country emerging market ETFs such as Deutsche X-Trackers Harvest CSI 300 China A-Shares (ASHR) and iShares MSCI Mexico (EWW), both held by Marketfield Fund, trade with tight bid-and-ask spreads of just one penny.

Rosenbluth says the increasing use of ETFs in mutual funds is a good thing for advisors.

“Advisors using active funds will benefit as ETFs provide a targeted, low-cost approach to gaining exposure to an investment style…. If the asset manager is buying low-cost ETFs and by trading more efficiently, ETFs can help the mutual fund keep costs low.

But performance is what’s paramount. “Whether a manager is using stocks or ETFs that hold stocks should matter less than how the fund has performed and are the securities inside the portfolio worthy of holding,” says Rosenbluth. “A transparent, diversified ETF is easy for an investor to understand or conduct due diligence on.”

A recent Deutsche Bank Markets Research expects “active & passive investment strategies co-existing in portfolios together in a more balanced fashion in the future.” Even though the report focuses on an either/or scenario, choosing ETFs or mutual funds, it notes that mutual funds are regularly using ETFs as a core investment, a temporary investment for short-term cash inflows – a practice known as “cash equitization” – and for liquidity management purposes. 

But it notes that if ETFs are not part of a fund of fund’s portfolio “their usage tends to be more tactical with relatively high turnover.”

Deutsche Bank expects that passive strategies, including ETFs and index mutual funds, will continue to gain market share vs. active funds for at least another three to five years. Advisors will be using more ETFs as more convert to fee-based practices as a result of the DOL fiduciary rule; so will robo-advisory platforms as they proliferate as well as defined contribution plans, according to Deutsche Bank.

In the meantime, net new assets for ETFs in a number of retail channels — RIA, IBD, wirehouse and discount brokerage — rose by $205 billion, or 9%, in the first three quarters of 2016, according to Broadridge Financial Solutions. RIAs led the increase, with ETF assets up $76 billion, or 14%. In contrast, net new assets for mutual funds in the RIA channel grew by only $20 billion, or 1.2%.

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