Revisiting the active-passive debate: Can we all get along?

A perspective from E*TRADE Capital Management, LLC

07/27/18

As debates go, this one is pretty bloodless. Some would say it’s not a debate at all—just a realignment of sorts. Still, the advent of passive investing is reshaping the investment landscape in ways few could have imagined even a decade ago, making the active versus passive discussion worth revisiting.

Once upon a time …

In the not-too-distant past, investors’ choices were relatively limited. On one hand were individual stocks and bonds, which could be difficult to access and often came with hefty commissions (before E*TRADE and its peers came along, that is). On the other hand were mutual funds—including their close cousins, index funds, which were born in the mid-1970s.

That was about it.

Sure, more sophisticated hands could dabble in options and commodities. But 25 years ago, investors’ retirement savings were more than likely concentrated in individual securities, actively managed mutual funds, or index funds.

The rise of ETFs

In 1994, State Street Global Advisors introduced the first exchange-traded fund (ETF), which tracked the S&P 500® index and remains the largest ETF in total assets to this day.1 Many ETFs incorporate the same passive strategies as index mutual funds but offer the advantage of trading on major exchanges much like traditional stocks.

In recent years, ETFs have exploded in popularity as the passive vehicle of choice for retail and even some institutional investors. No longer limited to tracking common benchmark indexes, ETFs have evolved to include a wide range of more complex strategies, including smart beta and factor-based approaches.

Many of these ETFs feature rules-based methodologies that sever the link between a company’s market capitalization and its weight within a portfolio. For example, some smart beta indexes weight constituents by metrics such as book value, cash flow, or sales rather than market cap.

Changes in fund flows are reshaping asset management.

The migration to passive strategies

Low-cost passive strategies have upended an investment landscape traditionally dominated by actively managed funds. Consider:

•   Over a 10-year period beginning in 2007, investors withdrew $1.2 trillion from actively managed US equity mutual funds, while putting $1.4 trillion into passive equity products.2

•   Global ETF assets increased from $417 billion in 2005 to $4.2 trillion by mid-2017—a compound annual growth rate of roughly 21%.3

•   In 2017, passive funds across all categories—including fixed income and alternatives—saw $692 billion of inflows, with ETFs accounting for most of the total. Meanwhile, actively managed funds saw outflows of nearly $7 billion, which was actually an improvement from previous years.4

Passive products have created so much disruption that some market observers have questioned the long-term viability of traditional actively managed mutual funds.

But through it all, many mutual fund complexes have maintained their brand equity, loath to relinquish skilled stock pickers in their quest to generate “alpha”—i.e., a return in excess of a market benchmark.

And despite flows that favor passive strategies, active strategies still make up the majority of US assets. In fact, Morningstar calculates that ETFs account for less than 20% of all US investment assets—at least partially because mutual funds still dominate retirement accounts.5

Expense ratios: The race to zero

Still, recent flow trends speak for themselves. Why have passive strategies gained so much momentum? While there are many reasons, cost is an overriding factor. According to Morningstar, the average asset-weighted expense ratio for actively managed funds was 0.72% in 2017. While that’s down from 0.75% in 2016, it’s still 60 basis points higher than the 0.15% average asset-weighted expense ratio for passive funds.6

Among ETFs and actively managed funds, investors now hold more than 80% of assets in funds with below-average management fees.6 This is all part of a “race to zero” that has seen management fees fall precipitously as low-cost competition has intensified.

But there is more to this tug of war than cost, and, as many financial advisors can attest, active and passive strategies each have their own merits.

Advantages of active management:

•   Active managers have the flexibility of moving in and out of sectors as conditions warrant (subject to broad investment mandates), and they can potentially outperform the market with timely stock selection.

•   Many active managers have a team of analysts and can use fundamental research to help make informed investment decisions.

•   If investors focus on mutual funds with specific attributes, they greatly increase their chances of outperforming passive products. These include low expenses, a long-term orientation (meaning low turnover), funds that are meaningfully differentiated from their benchmarks (not closet indexers), and portfolio managers who are invested in the funds they manage (so their interests are aligned with investors).

Advantages of passive strategies:

•   Passive strategies often come with lower expense ratios, and, in the case of many ETFs, they may not generate capital gains, which can improve tax efficiency.

•   Active managers have had a hard time outperforming the market. In fact, over a 15-year period through 2017, more than 92% of US active managers failed to outperform the market.7

•   Passive funds are often transparent, releasing holdings daily, with strategies that are generally easy to understand.

•   Did we mention cost?

Context is king

As with most debates, common sense can be found in the middle ground. In reality, few investors are married to one strategy over another. Nor should they be.  

•   There is no one-size-fits-all solution. Just as investors’ financial goals vary, the solutions they choose to achieve those goals can and should differ. If your goal is to maximize tax efficiency, ETFs may be a sound choice. If you’re more comfortable with having professional portfolio managers oversee your assets, active strategies could be a better fit.

•   Not all ETFs are the same. Not all ETFs are constructed around market-cap-weighted indexes. In fact, many multi-factor ETFs are quasi-actively managed. However, that can also mean higher expense ratios and methodologies that aren’t as transparent.

•   You can mix and match. Depending on your financial goals, a healthy mix of active and passive strategies can make a lot of sense—particularly for added diversification.

•   Asset class matters. Deciding whether to pursue an active or passive approach can also depend on the asset class. For example, active managers may gain more of an information advantage in emerging markets or in certain segments of the fixed income market than in large-cap equities, which are more heavily researched and widely traded.

Despite what can occasionally seem like a Foreman-Frazier match, this contest of ideologies may be something closer to a gentlemen’s agreement. After all, investors can use a wide range of strategies to construct a diversified portfolio—including actively managed funds, factor-based ETFs, and traditional index funds.

What’s important is that investors base their decisions on their own risk tolerance, time horizon, and financial goals. Regardless of which approach you choose, diversification can be the best tool for giving market volatility a knockout blow.

1.    Wall Street Journal, “As First ETF Turns 25, Exchange-Traded Funds Dominate Investing World,” Jan. 22, 2018. https://www.wsj.com/articles/as-first-etf-turns-25-exchange-traded-funds-dominate-investing-world-1516626000

2.    Credit Suisse, “Looking for Easy Games: How Passive Investing Shapes Active Management,” Jan. 4, 2017. research-doc.credit-suisse.com/docView?language=ENG&format=PDF&sourceid=em&document_
id=x745112&serialid=knrGGNw%2Bo620toTTx96qBQ%3D%3D

3.    EY, “Reshaping around the investor: Global ETF Survey 2017,” webforms.ey.com/Publication/vwLUAssets/Global_ETF_Survey_2017/$FILE/ETF_Survey_Lux%20-%20LR.pdf

4.    Morningstar, “Morningstar Direct: Asset Flows Commentary: United States,” Jan. 18, 2018. https://www.morningstar.com/lp/fund-flows-direct?cid=CON_DIR0020&con=11136

5.    Morningstar, “5 Charts on U.S. Fund Flows That Show the Shift to Passive Investing,” March 12, 2018. https://www.morningstar.com/blog/2018/03/12/fund-flows-charts.html

6.    Morningstar, “U.S. Fund Fee Study: Average Fund Fees Paid by Investors Decreased 8% in 2017, the Largest One-Year Decline Ever,” April 26, 2018. https://www.morningstar.com/content/dam/marketing/shared/pdfs/Research/USFundFeeStudyApr2018.pdf?cid=EMQ_

7.    S&P Dow Jones Indices, SPIVA® U.S. Scorecard, Dec. 31, 2017. https://us.spindices.com/documents/spiva/spiva-us-year-end-2017.pdf