A heightened focus regarding fees and investor protection has generated an increased number of headlines around the decades-old debate between active and passive fund management. Historically, investors have viewed the two theories of management as one-verses-the-other, and many investors have been known to fluctuate between the two based on which style is in favor; in recent years, the trend has tilted toward passive management. Lower volatility, monetary policy and economic recovery have made it more difficult for active managers to consistently beat their benchmarks. However, history tells us that when passive management becomes oversaturated, the pendulum often swings back toward active. While we don’t anticipate a major shift away from passive, there are attractive aspects of active management that should be considered – and we believe that a combination of both styles creates a strong and timeless portfolio.
The shift to passive fund management
Investing in passive mutual funds is unquestionably a way to reduce investment fees that can drag on fund performance while maintaining exposure to a wide variety of investment styles. Fee-conscious investors, Financial Advisors and Broker Dealers are all embracing the idea of balancing less active portfolio management and research against the potential of earning benchmark returns from simply tracking the overall market.
Passive funds are particularly attractive in areas where markets are extremely efficient, where information is readily available, and where the ability to uncover opportunities to beat the market is rare. Take the U.S. large-capitalization segment for example; only 5% of portfolio managers in that segment who beat their index for three consecutive years also beat their index the following three years, according to S&P Dow Jones Indices*. Passive funds can also be an attractive tax-efficient investment; particularly those that track more narrowly focused benchmarks.
Overall, the mutual fund industry has benefited from the increase in the number of passive funds. Low-cost providers have driven down the cost of active funds, while sharpening the focus of active managers on performance and fund expenses.
Do investors still benefit from active management?
We think so. While passive funds may be attractive from a fee and tax-efficient standpoint, they do have drawbacks. Markets have inefficiencies, which passive managers cannot exploit. Managers following an index lack the ability to make adjustments based on market conditions and research discoveries. For instance, active managers can judge when to raise cash levels, in order to reduce potential downside exposure, when markets react to external events. Active managers also have the ability to weight holdings according to where they see value, while most passive approaches are weighted to align with the chosen index, for instance by market capitalization – giving more exposure to well-established companies that may have less growth potential.
Fixed income is an area where greater market inefficiencies exist. For example, the Bloomberg Barclays Aggregate Bond Index only covers roughly half of the universe of bonds available to active managers. In the municipal bond segment alone, there are over 50,000 issuers and 1.5 million cusips. Robust new issue calendars, lack of transparency in bond pricing and changes in credit quality have made ongoing hands-on credit analysis a valuable feature of active municipal bond management. Passive bond fund managers lack the ability to realign security weightings in a bond portfolio, effectively manage duration, or hedge exposure to certain sectors.
Which active funds are worth considering? Following are key aspects to consider when evaluating actively managed funds.
• Difficulty to replicate – active funds can offer exposure to investment segments that indexes may not replicate. In inefficient markets where there is less information available, for example in emerging markets, small-cap, municipals and international equities, active managers have the opportunity to discover securities that may not be covered by an index.
• Dispersion – Active managers need dispersion of returns to show their skill. In segments where returns cluster in a narrow range, we can assume that the markets are efficient and investors may not benefit from active management.
• Active Share – for equity funds, active share measures how far a fund deviates from its benchmark. While active share doesn’t automatically correlate to higher returns, it shows that the fund is offering exposure to areas that investors may not have access to through a passive investment.
• Length of investment – actively managed funds should be primarily considered for long-term investable assets that are held over a full investment cycle. An active manager is unlikely to beat a benchmark every year – for them it’s about time in the market, not timing the market.
• Broad mandates – Managers that have fewer restrictions around the regions, asset classes or securities in which they can invest may have the ability to find investment opportunities missed by managers with narrow guardrails.
Bringing it all together
Aquila Group of Funds offers nine actively managed mutual funds, and we believe there is value in our in-depth research and disciplined management process. We also recognize the benefits of utilizing active and passive management together to achieve investment goals while taking advantage of the strengths of both approaches.
For a long-term strategy, blending management styles allows investors to use passive strategies for access to highly-efficient markets or to tactically take advantage of short-term market conditions, while selecting active managers when they want exposure to areas of the markets that require more hands-on research or that can’t be easily replicated by an index. The extent to which a combination of both styles varies between passive and active depends on risk tolerance, investment goals and market conditions, and may be adjusted over time.
* The S&P 500 Dow Jones Indices study was conducted using the period from March 31, 2000, through Sept. 30, 2016, based on the earliest availability of Lipper style classifications.
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