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Active a Harder Sell but Advocates Make a Case

By Rita Raagas De Ramos April 18, 2017

Active funds are becoming a harder sell to investors – who have increasingly turned to passive funds – because of their relatively higher costs and their general long-term underperformance. The move toward advisors looking after investors’ best interests in retirement accounts – now an expectation, with or without the Department of Labor fiduciary rule – has also been making passive investments even more attractive.

But proponents of active investing say it would be wrong for investors and advisors to continue to retreat from active investments. They say there are active investments that are outperforming, and going after cheaper alternatives doesn’t mean advisors are serving their clients’ best interests.

Largely motivated by fear of potential litigation spurred by the proposed DOL fiduciary rule, retirement advisors are shifting to lower-cost investment products. Fees and share class suitability have been the focus of several lawsuits against retirement advisors.

Retirement advisors surveyed in June to August by FA-IQ sister publication Ignites Research said they were allocating more client assets to index equity mutual funds, products mixing active and passive strategies, index fixed-income mutual funds, ETFs and target-date funds. Ignites Research surveyed 281 of the Financial Times’ Top 401 Retirement Advisors.

Industry reaction to the fiduciary rule seems to have accelerated a move that was already underway. The FT 401 advisors surveyed by Ignites Research increased their clients’ allocations in index-tracking U.S. equity funds to 9% in 2016 from 8% in 2015. In contrast, advisors reduced client allocations to actively managed U.S. equity funds to 25% in 2016 from 28% in 2015.

“What we have been seeing is a misinterpretation of the fiduciary rule,” says John Frownfelter IV, the Oaks, Pa.-based managing director for investment solutions at SEI Investments. “Advisors think they need to provide the lowest cost to be a fiduciary to investors. You get what you pay for – you’re paying less but you’re getting less. Just providing low cost across the board is not providing investors with the best value.”

Dennis Stanek Jr., a Hartford, Conn.-based financial advisor at RBC Wealth Management, says advisors are generally motivated to avoid any liability, and “that fear, in turn, is driving everyone to rotate out of actively managed portfolios and into the same index funds pushing up valuations and attracting even more money.”

Instead of focusing on shifting to passive from active, “maybe the more prudent play is to shift from revenue sharing funds to zero revenue funds,” says James Sampson, Boston-based director for retirement advisory services at consulting and advisory firm Hilb Group Retirement Services.

“There are more factors to selecting a fund than just cost,” he says, adding that transparency and due diligence are key in fund selection. “Otherwise it would be like going to a restaurant and just picking the cheapest meal.”

SEI Investments’ Frownfelter believes advisors can still protect themselves against potential litigation even if the investment products they recommend to their clients are not the cheapest in the market.

“It all comes down to documenting their process. How did they conclude that the recommendations they gave their clients were appropriate? They can fall back on that research if litigation were to ensue,” he says.

RIA firm Bradley, Foster & Sargent, which manages $3.2 billion, has been receiving more queries from clients and prospects about passive and low-cost funds, says Charles Herbert, the firm’s Hartford, Conn.-based director of sales and marketing.

“Our high net worth clients have been increasingly aware of fees and costs. It’s almost as if they feel they would be remiss if they don’t ask us for low-cost products,” he says. “Some institutional clients insist on passive, low-cost products and have been requiring them in their RFPs, but that’s largely because they have to answer to an investment committee.”

But the firm invests around 95% of its clients’ assets in active funds, and it doesn’t plan to change that heavy bias toward active investing, says Herbert.

“We are not shifting our business model to passive just because it’s more popular than active and not because of the DOL rule,” he says. “Our main goal for our clients is to achieve market-like returns with reduced volatility, and we believe we can achieve that with active investing.”

Even without the move toward a best interest standard, years of underperformance by many active managers in the U.S. have made it more challenging to encourage many advisors and investors to stick with active investing.

In the 10-year period up to the end of 2015, 82% of large-cap fund managers, 88% of mid-cap fund managers, and 88% of small-cap fund managers in the U.S. underperformed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indexes, respectively, according to index provider S&P Dow Jones Indices.

Dennis Stanek

There are opportunities to be made from inflows into passive investments and outflows from active investments, says RBC's Stanek.

“Because the flow of money into index funds is pushing up prices, the flow out of active management is pushing down the prices of securities not in indexes. Both are, in my opinion, temporary and artificial. I believe it will take a bear market, a correction, a market dislocation or something to change the psyche or confidence of investors,” he says. “But I’ve learned that investing in securities when their valuations are low gives the owner the highest probability for good long-term positive returns.”

SEI Investments’ Frownfelter believes the market is already turning in favor of active investing, citing four reasons: the market has been on an extended bull run since 2009; small-cap stocks are outperforming large-cap stocks; international stocks are outperforming domestic stocks; and stocks have high dispersion and low correlation.

“With the new administration, economic growth, and the Fed increasing interest rates, we are seeing greater dispersion and low correlation between stocks, and that makes it easier for active managers to pick securities that will outperform,” he says.