When Active Fund Management Makes Sense for Investors

Couple Meeting With Financial Advisor
Getty ImagesHigh-yield municipal bonds and international small cap funds are solid choices for active management.
By Kate Stalter

The debate between active and passive management may never be settled, particularly in the media. Plenty of investors, advisers and academics hold strong views on either side.

But there are some who believe that a combination of active and passive management styles is in investors' best interest.

Daniel Kern, president and chief investment officer at Advisor Partners in Walnut Creek, California, is co-author of a 2014 research report, "Investment Selection: A Framework for Combining Active and Passive Investments."

The researchers used three metrics to evaluate passive and active funds in various asset classes: payoff, persistence and predictability.

Kern explains the criteria, saying, "Payoff means: Does active pay enough to justify the higher risk and cost? Persistence is: How frequently do winners continue to win? Predictability is: How often do active managers outperform?"

Kern and his colleagues identified a few areas of the market where active funds met those criteria. International small cap is one example. At Advisor Partners, Kern uses the Oakmark International Small Cap Fund (OAKEX), managed by David Herro.

Another aspect of Kern's analysis is evaluating whether traditional benchmarks appropriately capture the investments and risk profiles he wants to include in client portfolios. In the case of high-yield bonds, his firm gravitates toward active management.

"We think the benchmarks used for high yield are fundamentally flawed," he says. "Bond benchmarks reward those who borrow the most. Or, in less kind terms, benchmarks may reward bad behavior instead of good behavior."

Focused on Investments

When credit analysts and managers actively oversee a high-yield fund, they can focus on specific sectors and regions, and even narrow down selections to the better-quality bonds within the high-yield universe. Such selectivity isn't possible for a fund that simply tracks a benchmark.

"With an asset class like high yield, we'll use an actively managed fund, largely for risk-management purposes," Kern says. "We like having an experienced credit team at the helm making that choice about how much to invest in high-yield energy debt, in the international fixed-income market, in the debt of peripheral European economies."

%VIRTUAL-pullquote-We prefer to have active managers who say, 'There are problems. We don't want bonds from Illinois or Detroit or Puerto Rico.'%Michael Ball, president and lead portfolio manager at Weatherstone Capital Management in Denver, says active management is the better choice when it comes to high-yield municipal bonds.

"We prefer to have active managers who say, 'There are problems. We don't want bonds from Illinois or Detroit or Puerto Rico.' We like that people dig into some of those areas where it's often difficult to get a good view. It's not like looking at Pepsi versus Coke," Ball says.

He notes that an active manager can analyze several factors before deciding whether to include a holding. For example, with high-yield municipal bonds, it may not be readily apparent why a particular issue is rated lower than investment grade. "Is it a smaller issue, and they didn't go out and get rating for it? What type of a revenue bond is it? There are a multitude of factors that come into play," he says.

Ball leans toward tactical allocation, meaning he will adjust portfolios according to market conditions and other factors. He currently uses the Nuveen High Yield Municipal Bond (NHMAX) in client accounts.

Rick Ferri, founder and managing partner at Portfolio Solutions in Troy, Michigan, has written extensively about the advantages of using index funds. His books include "The Power of Passive Investing: More Wealth with Less Work" and "All About Index Funds: The Easy Way to Get Started."

However, he has identified three areas of the market where active management is advantageous: municipal bonds, high-yield corporate bonds and value-stock strategies.

Ferri says value stocks aren't a unique asset class, although many investors and advisers refer to them as such.

That's because value stocks offer exposure to a risk factor that is not sensitive to market-capitalization weightings. For example, market-capitalization sensitivity is typical in a passive investment that tracks a benchmark such as the Standard & Poor's 500 index (^GSPC) or the Russell 2000 index (^RUT).

Value Investing

In the area of value stocks, Ferri says even some products categorized as passive are, in fact, actively managed. For example, Dimensional Fund Advisors, whose products Ferri uses, employs factors such as price-to-earnings and price-to-book ratios when constructing funds. While the methodology is data-driven and there's no manager picking stocks based on an opinion or outlook, DFA's strategy does qualify as active, Ferri says.

Ferri also points to Research Affiliates, which uses non-market-capitalization-weighted, automated strategies to construct indexes. Its indexes are licensed by other companies, which package them into funds. Ferri says those strategies, too, are forms of active management.

"It's active management that's done with the creation of the index methodology," he says.

He points out that products from DFA, or those that license Research Affiliates' indexes, have higher turnover and expenses than a simple value index fund from Vanguard. Those managers must generate a higher return to make their products worthwhile.

Ferri says a fund that simply tracks a traditional index, such as the Russell 2000 Value index of small-cap stocks, may be a reasonable choice, but he sees potential problems. For example, because index fund holdings are well known, and rebalancing activities are publicized ahead of time, it's easy for hedge funds to make buys or sells before index funds. That can put a dent in returns for retail investors.

In addition, a value index essentially consists of the value components of a larger index, split off into a smaller offshoot. Ferri says investors may not get the real benefits of a more targeted value strategy if they go that route.

"You could probably get something more concentrated than that by using DFA or Research Affiliates," he says. "It requires some analysis of whether you want to do that or not."
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