Active Management's Death: Greatly Exaggerated

| About: iShares Select (DVY)

Summary

Active management, defined as security selection, is in decline due to high fees and underperformance relative to index ETFs and index mutual funds.

The “active” activity of asset allocation policy mix is much more important than security selection and is alive and well.

The investor can remove the risk and expense of active security selection, but cannot remove the risk of mis-specifying the active asset allocation policy mix.

Everyone is talking about active versus passive index investment management. On Tuesday October 17, the Wall Street Journal ran a series of articles on this topic and presented some dramatic statistics. The most telling was that "over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren - passive exchange-traded funds - while draining more than a quarter trillion from active funds". Morningstar responded with an article that concurred with the Journal's assertion that the battle has been won and that actively-managed funds will be "reeling" in the foreseeable future.

The articles highlighted causes of the decline in active management. The primary reason, of course, is the much lower fees charged for passive funds, but also that active funds as a group have underperformed their respective index-based peers. Fiduciary responsibilities in 401(k) plans have driven a large part of the shift as plan trustees shift to offer lower-cost index funds for these plans. Most recently, the new DOL fiduciary standard for all retirement accounts, including IRA's promises to keep the trend in place. Additionally, Michael Kitces, the respected financial commentator, published his own thoughts and gave some credit to the growth of the internet. He felt that new information tools to "shine a bright light on relative mutual fund performance" increased transparency and gave investment consumers better information with which to make decisions.

But, is "active" management really dead? It depends on how you define "active." When we think of active management we usually think of stock- or bond-picking. The active "security selection" model is certainly in decline, but in fact, the most critical "active" action of determining the asset allocation policy mix is now more important and actionable than ever with the advent of the myriad of inexpensive index ETFs and other index mutual funds. You can certainly remove the risk and expense of active "security selection" through index ETFs and index mutual funds, but it is impossible to remove the risk of specifying the wrong asset allocation policy mix.

The well-documented thesis surrounding asset allocation policy popularized by the Brinson, Hood and Beebower paper from 1986 supports this view. In that paper, it was shown that 93.6% of return was explained by the policy mix compared to strategy or security selection (though future updates and comments on this paper lowered the percentage). My recent article on this topic highlighted the chart (below) of cumulative total returns of the major asset classes over the past six years that showed a wide dispersion of returns. The choppy upward sloping lines (DVY, SPY, VNQ), the choppy downward sloping lines (DJP, VWO, GLD), and the flattish lines in the middle (AGG, MUB, LQD) certainly show the risk of being in the wrong asset class over a period of time.

Click to enlarge

Source: iShares, Morningstar

All the investment Noble laureates sound smart when they say avoid stock-pickers and just "buy the market", but they never say what the market is! The choice of the asset allocation policy is an active decision based on determining the universe of macro asset classes from which to choose factoring in risk profiles, cash flow needs, tax issues, and a myriad of other special considerations unique to the investor. Over the last six years, an overweight to emerging market equities (VWO, a big loser) and an underweight to U.S. dividend paying stocks (DVY, a big winner) would have provided very painful results for the supposed "passive" index fund investor who thought low fees were the only asset selection criteria.

So how do you pick the right policy investment mix? Are robo-advisors the answer? No, not really. Though they all mostly use the same analytical efficient frontier models, these models are all dependent on the assumptions used and the model inputs. From my recent article, Wealthfront and Betterment had quite different strategic asset allocations with different sector bets for the same hypothetical investor. Given those different investment portfolio profiles, we can expect the investment results to be different, and possibly disappointing, depending on how the scenarios play out. Most certainly, of course, the investor can choose a 'human' advisor who will go through a financial profiling and help determine the customized investment policy mix.

Removing the risk of active security selection properly places the focus on the asset allocation policy mix where significant impact on investment performance resides. Regardless of how the policy mix is chosen, the investor cannot ignore the critical role it will play in investment performance.

Disclosure: I am/we are long DVY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.