"Anybody who has an investment idea fabricates an index," declares Gigi Turbow Marx. The founder of Old Field Advisors in Melville, N.Y., is exaggerating only slightly. After all, the major providers calculate hundreds of thousands of indexes daily and indexing is attracting an increasing percentage of investment assets. One reason is the growing popularity of exchange-traded funds, including in 401(k) plans; a vast majority of ETFs are index-based.

This popularity is feeding on itself. “A lot of people just want to do the popular thing,” observes planner A. Raymond Benton of Denver-based Benton & Co. “I think investors as a group are very much the victims of recency bias.”

Investment professionals, however, generally don’t view choosing between active and passive strategies as an either-or question. According to FPA's 2015 Trends in Investing Survey, 61% of advisors believe a blend of active and passive strategies provides the best overall investment performance.

Still, if you look at the flow of funds data, active portfolio management may strike you as a dying business. Morningstar reports that active broad U.S. equity funds saw outflows of $152.7 billion in the 12 months that ended in May. Over the same period, passive funds in that category added $157.2 billion. All told, indexing accounts for almost 39% of all assets in the broad U.S. equity category and close to 31% of all long-term assets.


Their rock-bottom cost appeals to both retail investors and advisors alike. “I tend to focus on low-cost investments,” acknowledges Peter Melsness, founder of Superior Financial in Rochester, Minn. But even as this advisor plants himself firmly in the passive camp, he still finds some actively managed investments attractive. “I’m not opposed to actively managed funds or strategies,” he says, “but they need to be low cost.”

While Melsness says his client portfolios are 70% to 80% indexed, Benton takes the opposite tack. “Most of the portfolios I do are probably 80% active,” he says. Yet he acknowledges that advisors need a good reason to use something other than an index fund. The advisor cites Capital Group’s American Funds family as being “relatively cheap” and offering long-term outperformance. “Why settle for the index return,” he asks, “when you’ve got something that has an established record of doing better?”

Aside from cost, advisors often consider other factors when choosing between active and passive instruments. For many, where we are in the market cycle is important.

“In a bull cycle, the index funds tend to outperform pretty significantly,” says Rob DeHollander of DeHollander & Janse Financial Group in Greenville, S.C. Since 2009, he says, indexing has looked really strong. “Indexers,” he concedes, “have bragging rights.”

But in sideways or down markets, DeHollander contends, “good actively managed funds tend to outperform.” He likens bull markets to sailing with the wind at your back. But when seas are becalmed or choppy, the “rowing” done by active managers can be a better choice.

The asset class in question may provide another reason to go with an active strategy over a passive one. “In the fixed-income space — particularly in a rising interest rate environment — in the alternative space, and in small-cap and emerging markets, we prefer active funds,” DeHollander says.


Marx of Old Field Advisors also prefers active managers when it comes to fixed income. Having spent years working in the bond market, she considers it imprudent to buy bond indexes that give the greatest weight to the most indebted companies or countries. “I think the best deals are in smaller or more arcane issues,” she says, adding that good fund managers understand the bond covenants and know if they are adequate.

Marx also differentiates between accumulation portfolios and those designed for distribution. “For someone who’s got an accumulation portfolio, it’s probably not terrible to use an array of passive indexes,” she says. “But as soon as you get into a situation where you really need to be looking at income, I think that’s where the passive approach really fails.”

What should advisors look for when picking an active manager? One factor to consider is that the usual benchmarks may be the wrong way to evaluate performance. Brian Huckstep, the head of strategic asset allocation at Morningstar Investment Management, runs a unit that researches managers and provides portfolio construction advice for various financial services firms. Huckstep’s group builds a blended benchmark for each manager. “When we evaluate managers, we don’t just look at managers against one benchmark,” he says.

The Morningstar analyst notes that large-cap managers will often hold some small- and mid-cap stocks. Yet last year, domestic equity managers who held 10% in foreign stocks underperformed when measured against a traditional large-cap benchmark like the S&P 500 or the Russell 1000. A cash position can also affect performance, Huckstep says, noting that in a rising market it can be a drag, but in a declining market it can boost performance.

“The reality is that you shouldn’t only use quantitative measurements, because they’re not adequate,” Marx says.

Benton concurs. “It’s not purely a quantitative determination,” he says. For that reason, he likes Morningstar’s forward-looking analyst ratings, which consider a fund’s process, stewardship and value. Typically, he considers active funds that “have a tendency toward more concentrated best ideas.” His fund choices also aren’t afraid to hold cash, if they can’t find suitable investment ideas, and are willing to close to new investors, if too much money comes in.


Manager changes can send an important signal, too. “When we look at trailing returns, we want to make sure that the team at the helm is responsible for those returns,” DeHollander says.

Huckstep adds, “When there’s a manager change, we want to meet with the team and understand how much of historical alpha has been the result of one or two star managers versus a team of analysts or the process in general.”

The team and its process can be the decisive factor. Benton notes that at fund companies with long histories of success, “analysts are treated with respect.” Ultimately, DeHollander says, if a team beats its benchmark repeatedly without incurring outsized risks, he considers using the fund. And if he can’t find an active fund that is doing that, he buys the index.

Marx describes the recent surge in low-cost indexing as a “correction to an asset management market that has been grossly overpriced. Does that mean that all active managers are toast?” she asks. “No. It means the good ones will stay in business and the less-good ones — maybe they’ll have to find a new career.”     

Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook.

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