Although the debate continues over whether active or passive management strategies are more important for a portfolio's long-term returns and diversification, the truth is that both sides of the management spectrum are still required for investment success.
Strategies and products from active and passive managers continue to complement each other in portfolios.
ETFs and other passive investment vehicles have benefited tremendously from the growing pressure on active managers, especially those that oversee mutual funds, to lower their fees. However, active managers are adjusting to this trend, and continue to give passive managers a run for their money.
ACTIVE MANAGERS ARE ADAPTING
Actively managed products experienced massive outflows last year, but 2015 wasn't an anomaly. Active managers had struggled for the previous five to six years following the financial crisis, and their high fees remain a difficult hurdle to overcome.
New regulations under the fiduciary rule, which will go into effect next April, will likely accelerate trends that will drive active managers' fees lower.
First, the fiduciary rule will further push the investment management industry toward fee-based, as opposed to commission-based, products. Currently, numerous share classes with different fee structures exist, but under the rule, institutional and lower-cost share classes will likely pull ahead as fee-based products become more common.
Second, the rule is expected to encourage more active managers to offer their strategies through fee-based managed accounts, which offer less expensive and more controlled access to mutual funds and other actively managed products.
Active managers can also add value for investors, and justify their fees, by offering multi-asset, multi-allocation funds with strategies that incorporate both macroeconomic trends and stock-picking.
COMBINING THE BEST OF BOTH WORLDS
One type of product that offers the benefits of both active and passive investing is the smart beta ETF.
These ETFs are tied to indexes that primarily weight companies using market factors such as momentum and value instead of market capitalizations.
These strategies will perform differently than traditional indexes, so investors and advisors need to fully understand each smart beta ETF's strategy before they invest in them, and managers offering these products should make sure they clearly articulate how their products function to avoid confusion.
The NextShares exchange-traded managed funds launched by Eaton Vance last year also serve as viable active/passive hybrid vehicles for investors. The funds trade on exchanges like ETFs, but are managed using rules-based strategies from investment managers, like mutual funds.
They can also issue and redeem shares in kind, and possess no 12b-1 or distribution fees, making them considerably less expensive than mutual funds. On the other hand, like mutual funds, these funds do not require managers to disclose their holdings every day, which enables managers to safeguard their intellectual capital.
NextShares provide many benefits to investors as well as active managers, especially on the fixed income side (where managers are especially sensitive about competitors creating portfolios with the same credit quality), so they will likely grow in popularity - and that may lead to competing products with similar structures entering the market.
ACTIVE & PASSIVE PERFORMANCE
The performance-assessment metrics for active and passive managers also, in their own way, show that neither active nor passive strategies should account for a portfolio's total exposure.
For active managers, investors and advisors can evaluate performance returns, but performance isn't the best measurement to use because managers may take considerably more or less risk than their benchmarks, and risk tolerance varies among investors.
This is why the simplest and most effective way to evaluate an active manager's performance is to review alpha-generation over the previous three to five years. This measures a manager's excess return over a benchmark. But only a small minority of active managers is able to outperform their benchmarks, generate alpha and offer low fees.
For passive managers, tracking error and portfolio liquidity are important metrics, but their effectiveness depends on the types of assets in their portfolios. A high tracking error indicates that a strategy doesn't track its underlying index closely, while a low tracking error indicates a tighter adherence to the index.
Portfolio liquidity, too, is an import consideration when selecting ETFs, as the spread between the price you can buy or sell the ETF can be much wider for portfolios with less liquid holdings. ETFs tracking indexes composed of large and diversified manufacturers, for example, will likely be more liquid than counterparts tracking niche retail companies.
In general, investors should focus on cost-efficient beta to truly determine whether or not a passive investment vehicle can meet their individual long-term portfolio needs. If a passive product has good liquidity and tracking, and it's also the cheapest offering, then it would likely be a good choice.
But unlike actively managed products, passive vehicles rarely outperform their benchmarks, so they can't provide the alpha that their actively managed counterparts generate.