Journal of Financial Planning: August 2016
Tim Clift is chief investment strategist at Envestnet | PMC (www.investpmc.com).
Current trends in asset management and within the ETF space indicate that the active versus passive management debate may soon become outdated. New strains of investment products seek to combine the attributes of active and passive management so that investors benefit from active management in the more flexible, transparent, and cost-efficient manner associated with passive management.
For example, Eaton Vance’s NextShares exchange-traded managed funds, which launched last year and were advertised as “the first exchange-traded products to be fully compatible with active management,” are structured like ETFs and trade on exchanges, but are actively managed according to rules-based strategies established by investment managers, like mutual funds. However, unlike ETFs, they are not required to disclose fund holdings on a daily basis, which protects the privacy and intellectual capital of their managers. This feature can also prevent trading costs from rising and performance from suffering due to so-called “front-runners” (traders who anticipate trades from large investors and try to buy and sell ahead of those trades to obtain short-term profits).
NextShares products have no 12b-1 and distribution fees, and can issue and redeem shares primarily in kind, mitigating flow-related trading costs. Mentioning these attributes is not meant as an advertisement for NextShares, but rather to illustrate that this and other new, non-traditional exchange-traded products that seek to combine the best characteristics of active and passive management have the potential to revolutionize asset management and reframe the active versus passive debate.
This type of product may be less expensive than mutual funds, but slightly more expensive than regular ETFs due to their active management component. With more products coming to market that are not strictly in the “active” or “passive” categories, financial advisers and investors will need to adjust their mindset when it comes to asset allocation and selection. The most common question used to be: is it worth it to pay extra for active management? Going forward, advisers and investors will have to ask: when is it appropriate to pay more for an investment product, and does this product meet the criteria?
Advisers can demonstrate their value by explaining how certain products attempt to combine the best characteristics of active and passive management, and working with clients to determine whether or not the products in question are worth their fees given performance history, potential for alpha generation, correlations to other asset classes, and client goals and time horizons.
The Rise of Smart Beta
The smart beta ETF is another relatively new investment product that is changing the way we think about active and passive management. Smart beta (also known as strategic beta) ETFs infuse aspects of active management by following indexes that are designed to be “smarter” than traditional indexes, which weight companies according to market capitalization. Weighting companies by market cap gives investors the most exposure to the largest companies without taking into consideration other factors that research has shown to indicate long-term potential for growth and outperformance, and this approach can lead to serious losses if the more heavily concentrated holdings experience an unexpected downturn.
The rise of smart beta ETFs is one of many trends spurred by the financial crisis of 2008, when investors saw first-hand that traditional asset allocation strategies and investment approaches could not adequately protect them in extreme market conditions. Smart beta ETFs are designed to provide investors with more targeted exposure that can strengthen their risk-return profiles and help them better navigate evolving market environments.
Instead of market capitalization, the indexes underlying smart beta ETFs weight companies by value, momentum, and other factors shown to yield long-term outperformance. The deliberate use of alternative weighting criteria to improve performance makes smart beta ETFs more “active” as opposed to “passive,” and as a result, more expensive than regular ETFs. As these instruments continue to rise in popularity, financial advisers can work with clients to determine whether or not a specific smart beta ETF’s projected and historic outperformance make its fees worth paying.
Some advisers and investors believe that smart beta ETFs are worth having in portfolios despite their higher fees. Earlier this year, BlackRock’s iShares business announced it anticipates global smart beta ETF assets to reach $1 trillion by 2020, and $2.4 trillion by 2025—with minimum-volatility and multi- and single-factor ETFs accounting for more than 60 percent of new smart beta ETF flows through 2025. In its announcement, iShares cited Bloomberg data that pegs smart beta ETF assets at $282 billion as of March 31 of this year. This means that if the iShares projection about smart beta ETF growth is correct, it reflects an annual growth rate of 19 percent, which is double that of the ETF market as a whole.
ETF Strategists Go One Step Further
Smart beta ETFs and similar products that seek to deliver long-term outperformance by combining the benefits of active and passive management are changing the game, but as exchange-traded products, their strategies cannot be customized for investors and individually may not provide a total solution for an investor. ETF strategists take these products to the next level because they offer diversified multi-asset portfolios that use the low-cost building blocks of ETFs with the oversight of an active manager to select and manage a diversified portfolio.
At the end of 2015, BlackRock reported that ETF managed portfolios represented approximately $350 billion in assets. This rapidly growing segment of the investment market shows investor appetite for low-cost solutions paired with active management.
Traditional SMAs Are Still Appealing
There are exceptions to this low-cost trend. Separately managed account (SMAs) are still filling a need for investors who want control and customization that they can’t get with mutual funds or ETFs, such as custom tax management or the ability to overlay custom social or ethical screens to their investments.
According to Morgan Stanley’s Sustainable Signals: The Individual Investor Perspective report released in February, 84 percent of millennials and 76 percent of women view making investments that lead to a positive social impact as a key goal.
Tax-efficient investment strategies offered in an SMA format are becoming especially valuable to taxable investors given the trend toward higher tax rates. Our proprietary research has found that using portfolio tax management tactics can increase portfolio returns by up to 100 basis points per year. The capability to apply tax-efficiency screens to SMAs puts a new spin on the familiar question: is it worth it to pay extra for active management?
The demand among investors for access to actively managed strategies that offer the flexibility, lower fees, and transparency of passively managed products has led to the proliferation of investment vehicles that cannot be classified as strictly active or passive. This trend may benefit investors, but it also provides greater opportunities for advisers to change the conversation about asset allocation in ways that may help their clients improve their investment outcomes.