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The new passive-active management compromise

The choice need not be binary — but there are key caveats.

Businessman with cake in hands
Vincent Besnault | Getty Images

The presiding argument for investing in index funds and passive exchange- traded funds is simple: They tend to cost less and perform better than their active counterparts.

Certainly, in broad categories like large-cap domestic equities, it can be hard to make a case for active management: Only 12 percent of active U.S. large-cap growth funds, for example, beat passive peers over the last decade, according to Morningstar's latest Active-Passive barometer.

But while it stings to pay high fees for funds that — more often than not — fail to beat the broader market, it also hurts to sit through years like 2015 and 2011, when the broad market's returns barely beat the interest on a savings account. If you want something more for your money, you wouldn't be alone.

In fact, about 60 percent of investors say they prefer portfolios that combine passive and active management, with a passive approach in broad market areas and active management in narrower, less-efficient market segments, according to the results of a new E-Trade survey.

Compare that with 30 percent of surveyed investors who said they preferred a purely passive approach and 8 percent who favored an exclusively active one.

Is this blended strategy actually sound? It can be — if you are selective, said Ben Johnson, director of global ETF research for Morningstar

"The debate between active and passive is based on a false premise," Johnson said. "The world is complicated and it's not black and white."

While it's "exceedingly difficult" to pick a winning active manager in most large-cap U.S. fund categories, he said, data show that low-cost actively managed funds in mid-cap value, foreign and emerging markets have had a better success rate against passive peers, relatively speaking.

Active value managers have arguably benefited from the fact that value stocks as an asset class have generally suffered in recent years, making it easier to outperform benchmarks simply by choosing stocks outside the style box or rejiggering weightings, Johnson said.

"If 'large value' as a style is sucking wind, there's an easier hurdle for active managers to leap over," he said.

This advantage might only be temporary — and could even reverse if value stocks start doing better as an asset class, as Dunn's law predicts, Johnson said.

On the other hand, active managers in foreign and emerging markets may have a more enduring advantage, he said.

Whereas the U.S. market is relatively transparent and efficient, markets in developing countries have opacities and inefficiencies that could allow a well-researched active manager to gain an upper hand. Broad, cap-weighted index funds tracking developing markets tend to be heavy on Chinese stocks, for example, including state-owned enterprises with employment mandates that may supersede profitability goals, Johnson said.

"Active managers may instead underweight China or invest in developed-market equities with exposure to China, like Yum," he said.

The advantages that active managers boast — even in less efficient corners of the market — seem to disappear when the expenses their funds charge are above average, Morningstar's analysis found.

Whereas more than 60 percent of emerging markets funds in the lowest-fee quartile of the category beat passive peers over the past decade, less than a quarter of those in the highest-fee quartile did the same. And, across asset categories, no group of high-fee active funds beat passive counterparts more than 30 percent of the time over the last 10 years.

That's a case for choosing active funds carefully — and seriously scrutinizing fees, which can shave tens of thousands of dollars from your savings over the decades.

One piece of good news is that the big gap between active and passive fund fees — on average, 0.18 percent for passive funds versus 0.78 percent for active ones, according to Morningstar — is not going unnoticed by investors. Average fund fees paid are dropping, not because companies are lowering expenses but because investors are switching over to passive funds, Johnson said.

"Investors are voting with their feet," he said.

They are increasingly voting for passive funds, cheap funds, and both: Across categories over the last five years, investors pushed $1.7 trillion into the least-expensive quintile of funds, while pulling out $372 billion from all other quintiles. And, even though active funds outnumber passive ones by 8 to 1, passive funds brought in $576 billion more in assets than active funds in 2015 — primarily in U.S. equities.