The Case For An Enhanced Passive Investing Category

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The division between active and passive strategies has devolved into a two-legged stool. A stronger investment environment needs a clear third option: the enhanced passive category.

There has been a relentless increase in passively managed funds and the emergence of strategies that are very different than traditional index-tracking portfolios, but classified under the passive label. The time has come to support and highlight those investment approaches by assigning them a distinct third strategy type.

Enhanced passive includes most smart beta and factor-investing funds, including ESG and SRI strategies that are not actively managed through individual stock selection. Despite the interest in those strategies, they have gotten lost, without a clear category. For example, they suffer from being called a “so-called smart beta fund.” But enhanced passive is a much clearer category from which to start educating and warming up what is already the next big innovation in investing.

Many arguments have been made on the merits of an active (a human portfolio manager making buy, hold and sell decisions) versus passive (investments that track and index) approach to portfolio investment decisions. Passive management comes with lower turnover, fewer costs and generally reduced fees.

Active managers often leverage factor analysis and models to support the screening, selection and timing of trades. Both the DJIA and the S&P 500 have committees that ultimately make the decisions on index composition. Model, as manager, is a different approach from passive and active management. Enhanced passive occupies the space between the two and reflects the most promising academic research, which investors can access and assess on its merits. That research is applied in an automated model to identify positions and make adjustments within a fund.

The warning signs for passive investing

Industry participants, sometimes with a bit of glee, have predicted that passive investors will learn the hard way in the next market correction that losses will be much larger than in actively managed portfolios.

There are many products labeled as passive that would fall within the enhanced passive category and are designed to reduce the risk of downside losses. Predictions have been made that investors will pull out of passive more quickly than active funds in market downturns and make the market more volatile. In the short-lived Q4 2018 U.S. equity swoon, more AUM left active than passive. According to Morningstar, active U.S. equity funds in December of 2018 had $31.5 billion in outflows versus $45.6 billion in passive inflows. The S&P 500 fell over 9% in the December after falling almost 7% in October.

The Federal Reserve Bank of Boston published a paper on August 27, 2018, The Shift from Active to Passive Investing: Potential Risks to Financial Stability? One of its conclusions was that passive investors are less reactive to performance than active investors. One explanation is that passive investors believe they are exposed to less risk. Higher fees on active funds have had a negative impact on their long-term performance. Transparency and competition has been compacting the fee gap between active and passive; the expanding passive label no longer always equates to less expensive.

Read the full article here by David Merrill, Advisor Perspectives

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