The relative merits of active and passive management has been a hot topic among investors for the past few years, with passionate arguments on both sides of the debate. While they each have their own strengths and weaknesses, we remain committed to an active, disciplined and dynamic approach to investment management.

An active manager uses research and analysis to choose securities that will beat a benchmark, whereas a passive solution seeks to match a benchmark's return through an index mutual fund, exchange-traded fund (ETF) or separately managed account. Although passive solutions have outperformed in recent years, we see opportunities ahead for actively managed solutions.

1

Passive solutions have grown in popularity in recent years

Between 2007–2015, more than $1.2 trillion has been invested in index mutual funds and ETFs. Low interest rates, lower fees and greater availability in retirement plans have proven attractive to investors. The introduction of higher capital gains and income tax rates and the net investment income tax that was implemented in 2013 played a role as well, as active managers tend to generate higher realized gains through higher turnover.

2

Although market trends have favored passive management, active solutions have been more successful during volatile periods

With abnormally low interest rates and high correlation among stocks, it has been difficult for active managers to pick and choose winners. When looking at three-, five- and 10-year investment horizons, passive solutions seem like the better choice. However, during shorter, more volatile stretches (e.g., 2000–2002 and 2008), active managers were better able to generate returns that outperformed their benchmarks.

3

The changing market environment points to a return for active management

The Trump administration promises to cut tax rates across the board, increase fiscal spending and reduce government regulations. We may soon experience more normalized interest rates, increased earnings due to lower tax rates, less regulation and higher inflation — giving firms better pricing power and providing a more favorable environment for actively managed solutions.

4

In addition, correlations among companies in the S&P 500 are at their lowest in 10 years

Low correlations create an opportunity for active managers who rely on in-depth analysis and stock selection to outperform the market. We believe actively managed strategies will play a bigger role in meeting client objectives going forward.

“At BNY Mellon Wealth Management, we are and will continue to be an active manager in determining how assets are allocated, what portions of an allocation are managed actively or passively, and how this fits in with a client's broader wealth plan.”

Historically, the outperformance of small cap stocks over large cap stocks has a high correlation with active managers outperforming passive solutions. With small caps recently outperforming large, this may be a harbinger for actively managed solutions outperforming passive solutions going forward.

Maintain a long-term focus to take advantage of the cyclical nature of the markets
Keep an eye on market conditions

Passive solutions perform better when everything is highly correlated, or moving in the same direction. Active solutions have the potential to outperform when fundamentals play an important role in stock selection.

Make active decisions in asset allocation

Active decisions, such as adjusting for changes in the market, economy or investment environment, are dynamic in nature. Given that over 90% of a portfolio's variance of investment return can be attributed to the mix of asset classes, the most important decision in generating return on investments is an active one.1

Take an active approach to a blended solution

Instead of choosing between active and passive, investors should focus on when to employ each solution, as a blend of the two is likely to offer investors the best of both worlds: enhanced performance over time and lower volatility. Determining the best combination requires a disciplined process, a long-term view and active decision making.

  • Footnote

    1Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, “Determinants of Portfolio Performance II: An Update," Financial Analysts Journal, May-June 1991, pp. 40-48.

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