When Choosing Passive or Active Funds, Consider the End Result

Preliminary numbers show that passive U.S. equity assets passed active U.S. equity assets by about $25 billion, according to Morningstar’s August Fund Flows report. At the time of publication, it was still waiting for 70 or so funds to report their total net assets as of month-end.

If this result holds, passive’s share of U.S. equity open-end and exchange-traded fund (ETF) assets would be 50.15% versus 49.85% for active funds. Morningstar says this milestone has been a long time coming as the trend toward low-cost fund investing has gained momentum.

Active U.S. equity funds have had outflows every year since 2006, with roughly equivalent inflows into passive funds during that time. Over the past 10 years, active U.S. equity funds have had $1.3 trillion in outflows and their passive counterparts nearly $1.4 trillion in inflows.

Nick Nefouse, head of DC investment strategy and co-head of LifePath at BlackRock in NYC says, “Many plan sponsors are saying now they want to own an index. It gives transparency into what they own. If an investment benchmarks the Russell 2000, it’s pretty straightforward what participants are getting. Explaining underperformance of active funds is difficult; explaining it for passive funds is easier.”

But, Steve Deschenes, research and development director of Capital Group in Los Angeles, says the fact that index funds expose participants to the full brunt of market downturns is important to emphasize. This characteristic, he says, can make what should be a “safe” investment an “enormously risky one.” According to Deschenes, “Strong active managers can provide less volatility and a smoother ride.”

Nefouse agrees that plan sponsors are paying active managers to smooth out volatility, but he says some plan sponsors are moving to passive investments because an active manager may not be able to perform so consistently over time.

Capital Group has done a lot of research over five or six years about what works in active management and selecting active managers, Deschenes says. If plan sponsors choose a low-cost active manager, it will perform better. In addition, manager ownership in their funds has been proven to produce value over and above the fees it’s charging.

Deschenes also points to research from Capital Group that looked at 60-year case studies and analyzed how participants fared using an index strategy versus using Capital Group’s active funds. The study covered 20 years of retirement plan participation, 20 years of transition and 20 years in retirement. “Our funds resulted in $120,000 per year in retirement income versus $85,000 from using an index strategy—even if a participant had a higher lifestyle and more withdrawals. Our funds also resulted in $2.5 million in ending wealth at age 85 versus $1.5 million using an index strategy,” he says.

On the passive side, Nefouse points out that if a client wants a lower volatility portfolio, BlackRock can build an index that provides that. He adds that fund performance comes up a lot in conversations. “Comparing our indexes to other active manager strategies, we are line.”

The Bottom Line

The active versus passive debate has been going on for decades and will continue. However, Deschenes and Nefouse both agree that investor outcome is the important factor when deciding which funds to offer retirement plan participants.

“Neither active nor passive is monolithic; no one provides all passive or all active investments,” Deschenes says. “Good plan sponsors that have developed an investment policy statement (IPS) are looking for things that are proven, things that consistently add value and things that can improve participant outcomes.”

He points out that in the Employee Retirement Income Security Act (ERISA) and related guidance, nothing says plan sponsors have to always choose the lowest-cost funds; it says fees should be reasonable. “Fees must be taken in context with the value created for participants,” Deschenes says.

Nefouse says plan sponsors should look at client outcome, transparency and value for service. “If a fund can offer the desired outcome, with transparency and at a lower cost, plan sponsors should choose it. Start with the desired outcome then weigh active versus passive choices,” he says.

The investment conversation within the industry has been “myopically focused on fees,” according to Deschenes. “Fees are important, and investors should seek out low-cost funds if they help their chances of achieving greater than average outcomes. And those outcomes—sending a child to college, having a secure retirement—are actually what people care about,” he concludes.