Though the active versus passive debate remains alive among managers, from the client perspective, the burden is on money managers to demonstrate their value by finding "sweet spots" that increase returns and manage risks if they want to maintain record profits and compete with increasingly sophisticated passive investments, according to a new study from McKinsey.

The study found that traditional AUM rose 11% last year to a record $31 trillion in the U.S., Canada and Mexico. Revenue climbed about 10% to $111 billion and profits were up 12% to $37 billion, also records. Industry operating margins widened to 33%, the highest since 2007.

Active fund managers continue to hold on to market share against passive managers in the fixed-income area as investors seek higher yields.

To compete against fast-growing passive products, active managers will need to develop "a sharper and more nuanced framing" of how they add value that includes their return profile and approach to managing risk, according to the McKinsey report.

"Leading firms have already begun mining open source data for investable insights that can be used to deliver alpha," McKinsey said, referring to returns above market benchmarks.

Tim Clift, the chief investment strategist at Envestnet, explains that there is no clear cut right and wrong when choosing the right strategy for the end investor. Rather, Clift tells Money Management Executive that while there are benefits to be had from both approaches; and that managers will continue tinker with hybrid variances to meet the individual needs of their clients.

Clift adds managers are also being tasked with deciding how proposed regulatory changes will impact their strategies and what types of adjustments they may soon have to consider.

"The DoL's actions are expected to put further pressure on investment fees so the obvious winners would be low cost mutual funds and ETF's," Clift says. "I'd expect firms that have developed low cost, transparent, fiduciary solutions will gain the most assets."

How should asset managers approach the debate between passive and active strategies?

I am an advocate of combining passive and active together, so I would say that I am not an advocate of only one or the other. I think that they are both opposing but can also be complimentary management styles. There are benefits to both and I think that the way you construct a portfolio and where you decide to allocate to passive or active is really at the crux of the portfolio construction. What we want to look at is which asset classes and market environments where active tends to do well, where it tends to underperform and then the same for passive; then build a portfolio around that market environment and success rates we see within those underlying asset classes.

How do you vet the pieces of active and passive you feel are not effective?

When looking at the different asset classes, we take a long term view over the last 30 or 40 years, and we have done a research study for the last 12 years on which asset classes are able to add alpha in front of active managers on average.

So that is basically breaking down all these underlying asset classes and sub-asset classes and looking at their success rates.

That means, how many active managers are beating their benchmark versus how many are underperforming after fees and looking at them over different time periods - monthly or quarterly or over annual numbers - just to help get a sense of whether certain asset classes are more successful.

Those tend to be the less efficient asset classes, meaning there are a lot more securities or a lot less research behind them. If you think about small cap companies that are newer, or emerging frontier type of companies, or sector type of products that may not be as much in the mainstream; those tend to be areas where active managers tend to excel.

Then with the more efficient ones, the large cap for example where it's very over-researched and difficult to be able to outperform other asset classes. Then, secondarily, we look at the market environment.

So we look at forming themes. There are volatility correlations, the trend of markets - whether that's up or down - and then the efficiency of asset classes. So, each one of those will either benefit or hurt active managers and passive managers. For example, when the market is more volatile active managers tend to do better. When they are less volatile then passive will do better.

With higher correlation passive tends to do better, and with lower correlation active tends to do better, so there are these trends and themes we see within the asset classes too. If you can understand what type of environment you are in, you can also look at which classes you feel are able to perform better.

Can you explain how you examine these themes?

We tend to overweight or underweight our exposure to active managers or passive managers depending on those market themes.

So, high volatility versus low volatility market; the high volatility will benefit active managers on average and then low will benefit passive managers.

With an upward trending market, generally you are better to go passive or underweight towards passive and that is even broadening across asset classes. But generally, active managers are able to provide a little more downside protection and that could be because they are a little more risk-averse. It could be because they are holding more cash. It could be just because they can be active and out of the way more, but by-and-large when the markets are trending down, generally active managers will be outperforming in that type of market environment.

Can you discuss any misconceptions you may see with active and passive investing styles?

I think one of the misconceptions is that to be able to find an active manager, you are just looking at categories where the average manager beats the benchmark, and I don't think that's the best philosophy because when you look at asset classes you can find active managers that are beating the benchmark.

It may be that 50% or 10% are beating the benchmark, but there are always managers out there that are beating the benchmark. So, it takes more vigorous and due diligence and more work to find those, and in some categories it may be much easier to find an active manager that can beat the benchmark.

How is technology changing the way managers look view active and passive?

I think new technology makes access to these types of products easier. It has certainly helped to boom passive or ETF type of products grow and it has made them, certainly more mainstream so that investors can buy and sell intraday and quickly and very inexpensively.

I think that has been one of the trends, but I think the bigger trend is the question of costs or fees.

Investors are certainly looking much more closely at fees to see what they were paying in the past and still what makes sense to be paying and getting the benefit that they should see. Some active managers may, and if they are not they may start allocating assets to passive management. That is probably the biggest trend that we have seen and that has put pressure on active managers to lower their fees. It has also weeded out those more extensive managers that weren't adding value. So it has culled the herd, which I think is healthy. I think it concentrates more on the managers who have been more successful.

These tools in general, being able to look up on the internet in seconds to compare, from both a performance and a fee perspective, has just made it more readily available for consumers to make intelligent decisions.

So having it at your fingertips, there is much more transparency today and now quantitative data behind these investments where you might have had to directly call a fund company or get a perspective. It was never that easy to find all the information that they might have wanted on their investments.

Do you see more deviance from active and passive to a hybrid model in the years ahead?

I do think it is converging and we see that where traditionally more passive products or beta products, and there is this new interest in smart beta products; or actively managed passive products. So they are crossing the line there.

On the active side more specifically, we are seeing active ETFs starting to take off where you have active managers sitting inside the technology of the ETF to reduce the cost.

So both of these areas are really overlapping or combining, which is really making it interesting. I think as a result you are getting efficiency both from a cost and a structure standpoint by these new vehicles that are being created that take the benefits of active and passive together.

How might some of the impending regulatory changes effect passive and active strategies?

I think the Department of Labor's rules are going to put a lot of pressure on asset management companies in general.

I think active managers that have higher expense ratios, or higher cost products, are really going to have to justify an advisor recommending those investments, and that it is in the best interest of the client and that there aren't any better alternatives.

It certainly gives a leg up to passive type investments that will pass the test more easily but I think that the pressure is certainly going to be more on the active managers to prove their worth and to come up with solutions that will satisfy the DoL rules.

When asset managers look at their offerings they are looking for something that is more cost competitive. So, that could mean combining passive and active together - so they may be taking active managers thinking at a mutual fund company but not having all their solutions.

The answer for a client might be that only a couple of their solutions are a good fit, and then pairing that with passive management to help bring down the cost and also satisfy the rules.

So, I would expect to see a lot more of the combination of active and passive portfolios to be able to do that. -- With Bloomberg News. 

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