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Active vs. Passive: Not So Clear-Cut Anymore

As the distinctions between active and passive strategies become less visible, investors' due diligence must evolve, says Vanguard's Joel Dickson.

Ben Johnson: Hi, I'm Ben Johnson, director of global ETF research with Morningstar. I'm here on the sidelines of our sixth annual ETF Conference in Chicago, and I'm joined by Joel Dickson. Joel is head of investment research and development with Vanguard. Thanks for joining me, Joel.

Joel Dickson: It's a pleasure to be here, Ben.

Johnson: So, Joel, we just came out of a panel discussion in which we were talking about the age-old active-versus-passive debate. One of the things we touched on is that the entire premise of this debate might be false. Is it a false premise--active versus passive?

Dickson: Well, I don't know if it's necessarily a false premise, but certainly the lines have blurred between active and passive over the years. You think about it a decade or so ago, and there were these clear distinctions. The index fund was an S&P 500 or a total stock market index product, and active was individual security selection that managers were looking at to try to outperform the market.

But over the course of the last decade--and really, with the growth and emergence of ETFs--we have seen those two sort of opposites, if you will, come closer and closer together. Now, people may use index products to target a particular market, not necessarily to get asset-class exposure--although that may be part of it--but also to express a view on that market. Well, that's an active decision--an overweight or an underweight in a particular area. Or we're seeing the so-called strategic-beta or smart-beta products where you take active strategies and create indexes to track those. And then, we're still seeing the traditional active individual-security-selection approaches. So, this active-passive debate, I think, has lost, in many ways, a distinction; but I think that actually can be a positive because, at the end of the day, what we're trying to do is build portfolios that are appropriate for clients' risk and return characteristics. So, active-passive is really an implementation question about how do we best get the exposures that we want for our clients and to meet their long-term goals.

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Johnson: I want to delve into two things that you touched on in a bit more detail. The first is the active use of passive building blocks. So, when I move away from security selection toward beta or exposure selection in a non-purely strategic fashion, do I stand any better odds of being a successful active manager now that I've just simply changed the building blocks that I'm trading?

Dickson: Not necessarily. And that's, in some ways, that age-old debate within the active realm between individual security selection and, say, tactical-allocation approaches. And while you might get more diversified, broader exposure by using market segments or ETFs that track particular market segments, you're still making a bet that may be very risky, if you will, relative to your own personal benchmark or expectation about what returns might be. So, it's always calibrating against how much risk am I willing to take or want to take for the type of bet or the type of exposure that I want.

Johnson: This other blurring phenomenon that you mentioned before is in the space that we refer to as strategic beta. It's been called smart beta. It's essentially factor investing--rules-based active. So, what should investors know when they're doing due diligence on these strategies?

Dickson: I think that's the key--the due diligence piece. I think there has been some discussion about, "Is this a combination of active and passive because we're taking what might otherwise be considered an active construct, but putting it in index form?" But yet, what's the intent of the strategy--either from the construction standpoint or from how the investor is going to use it? And often, the key difference is that with an index-based approach--a passive approach--you're trying to gain market exposure, as well as the strategy at the lowest possible cost and with low tracking error.

Well, the smart beta is really trying to gear toward outperformance in some way. It might be more return or it might be less risk, but some sort of outperformance. Well, you're doing your due diligence from that sphere more like how you would do traditional active due diligence: What's the process that they used? Does the portfolio look like the process? Do I expect that what has happened historically to continue to do so in the future? And can I access it at a reasonable cost so that if there is outperformance that I think can be gained, it's not given up in the form of high cost? So, that due diligence process is much, much different. That's why we often want to refer to it not as strategic beta or smart beta, but as what it is, which is rules-based active. Ultimately, at the end of the day, the investor is going to use it like they do another active product.

Johnson: And the one item I heard you touch on repeatedly throughout this--the one item that really ties all of this together and gets us back to the fundamental math of asset management--is fees.

Dickson: It certainly is. We always like to say, "Let's first control those things that are most controllable." Whether it's active or passive--whatever the investment strategy may be--every dollar that you pay in fees is one dollar less that you get in return. So, all else equal, the fees matter most, and they are controllable. We don't know what market returns are going to be. We don't know when a manager is going to outperform or underperform; we just know there will be times when they do. But yet, the constant across that is fees. If you really want to increase your odds of success, low fees--and it's not just the the expense ratio, it's also the transaction cost that may be incurred in the implementation of the process--is one of the best ways to control that outcome better.

Johnson: Joel, thank you so much for being here.

Dickson: Thank you, Ben.

Johnson: For Morningstar, I'm Ben Johnson.