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The Case for Active and Passive Management

Apr 5, 2017

Passive investment options continue to grow in popularity and now represent approximately 40% of total equity fund assets1. They are efficient at providing broad exposure to a number of asset classes at a low cost. Active investing provides the potential for higher returns, but at the risk of underperformance, particularly during extended bull markets. Active management benefits from risk oversight and may provide downside protection relative to market benchmarks. We expect the performance of active and passive managers to be complementary over a full market cycle. Retirement plan sponsors that offer a diversified menu of active and passive managers to participants may provide smoother long term returns, as well as gain exposures to asset classes that are otherwise unavailable passively.

Defining Active and Passive Investing
Passive investment strategies provide broad exposure to select areas of the market at a relatively low cost due to their rules-based implementation. The performance of such strategies is tied to market capitalization-based indexes. Successful implementation is measured in terms of the manager’s ability to replicate the characteristics of the index and provide matching returns before expenses. The performance of a passive manager tends to be consistent relative to the target index, thereby reducing uncertainty about the role the fund will play in an investment portfolio.

Active investment managers seek to exploit inefficiencies in market prices that may exist due to considerations such as emotional rather than rational decisions, poor information, rigid investment guidelines or short time horizons. Unlike passive managers, active managers have the ability to react to market conditions and may employ various strategies such as security selection, sector rotation and/or market timing. Successful implementation is measured by the manager’s ability to outperform a similar benchmark and peer group on a risk-adjusted basis over a full market cycle. Fees tend to be higher relative to passive management due to the cost of investment research, personnel and typically higher portfolio turnover. Active investing provides the potential for higher returns, but at the risk of underperformance.

Active Management Benefits
Growth in the popularity of passive strategies has benefited retirement plan participants in the form of lower costs. As passive assets have grown, economies of scale have been achieved, reducing expense ratios. Active managers attempting to respond to increased passive fund competition have also experienced downward pressure on their fees. We believe plan sponsors should offer active as well as passive options to realize the following benefits: 1) risk management, 2) alpha potential and 3) broader asset class exposure.

Risk Management
While passive investors accept the full risk of the market, active managers may underweight asset classes or individual securities that may be overvalued. For example, many equity managers avoid investing in lower quality companies with poor balance sheets and weaker business fundamentals. These types of companies tend to lag during market corrections, such as the 2008 financial crisis and market sell-off from 2000-2002 following the bursting of the technology stock bubble. This may lead active equity managers to provide protection during market declines, which should contribute to a diversified portfolio’s risk-adjusted returns over a full market cycle.

Active fixed-income managers also provide risk management not available with passive investments. For example, U.S. government and agency securities, including agency mortgage-backed securities, now comprise more than two-thirds of the Bloomberg Barclays U.S. Aggregate Bond Index2. These sectors tend to provide less yield than corporate bonds and other “spread sectors” for a given level of exposure to interest rate risk. We believe there is value in allowing active managers to choose different risk exposures, perhaps by underweighting interest rate risk in favor of credit risk, while allowing for a similar expected return with a more balanced risk allocation.

Alpha Potential
If implemented effectively, active investment management offers the potential to generate positive alpha, defined as the degree by which a fund outperforms its stated benchmark. Even if the annualized excess return generated by an active manager is modest, compounding excess returns over a period of years can add up to significant gains for long-term investors.

We think that a thorough due diligence process helps to separate mediocre active managers from those who possess a durable competitive edge. A key component of this is qualitatively assessing whether the manager has a disciplined investment process that may be effective over multiple market cycles.

Broader Asset Class Exposure
Active management also provides access to asset classes that may be impractical or imprudent to offer on a standalone basis. For example, in the U.S. intermediate-term bond asset class, we prefer “core plus” active managers. Core plus managers may invest in securities outside of the Bloomberg Barclays U.S. Aggregate Index, such as high-yield bonds and non-agency mortgage-backed securities.

Active equity managers may invest up to 15% of their portfolios in non-marketable securities. This flexibility has allowed some active growth managers to add value over passive indexes by investing in private companies. Additionally, small cap and non-U.S. equity managers may invest in newly public equities prior to those stocks being added to passive indexes.

 
 



Conclusion
We believe retirement plan sponsors should include both active and passive managers on their investment lineups as a means of providing participants an opportunity to outperform broader market indexes, while reducing costs relative to a purely active portfolio. The combination of active and passive management may provide better risk-adjusted returns over full market cycles based on greater diversification benefits, including access to asset classes that are unavailable through passive options.


Author:
Newport Group Manager Research Team
March 2017






References
1 Lamy, Alina. “Morningstar Direct U.S. Asset Flows Update”
(January 2016) Morningstar. Inc.
2 The Bloomberg Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to their aggregate market prices. Most U.S. dollar-denominated, investment-grade fixed-income securities are included, including U.S. Treasury securities that are not inflation-linked, U.S. government agency debt, agency mortgage backed securities, corporate bonds and certain bonds issued by foreign entities that are denominated in U.S. dollars. Debt without fixed interest payments, such as U.S. Treasury Inflation Protected Securities, are also not included. Municipal bonds are also not included for tax reasons. Securities with less than one year to maturity and that do not meet certain sector-specific size requirements are also not included.



For Informational Purposes Only
Securities and investment advisory services offered through Newport Group Securities, Inc., (“NGS”), 300 Primera Boulevard, Suite 200, Lake Mary, Florida 32746, member FINRA (www.finra.org) NGS and Newport Group ae affiliated entities. Any information presented in connection with this communication is general in nature and is not intended to provide personal investment advice. This material does not take into account the specific investment objectives, financial situation and particular needs of any investor. Before investing, investors should consult with their tax, legal, or financial advisor and obtain a fund prospectus. The prospectus contains investment objectives, risks, charges, expenses, and other information that you should read and consider carefully before investing. Past performance is not a guarantee of future results. Any discussions concerning investments should not be considered a solicitation or recommendation by NGS. Any information presented about tax considerations affecting your financial transactions or arrangements is not intended as tax advice and cannot be relied upon for the purpose of avoiding any tax penalties. NGS, its affiliates, registered representatives and investment advisory representatives do not provide tax, accounting, or legal advice.
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