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.