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How To Explain Passive vs. Active to Clients

By Crucial Clips     May 17, 2017
The following text is a transcript of a portion of a speaker's presentation made at an industry conference or during an interview. This transcript solely represents the view of the individual who spoke, and not the view of Financial Advisor IQ or any other group.
Source: FA-IQ, Feb. 1, 2017 

BRUCE LOVE, MANAGING EDITOR, FINANCIAL ADVISOR IQ: Hi. This is Bruce Love with Financial Advisor IQ, and I’m here with Tim Baker, head of product strategy at Symmetry. Tim, if you are a financial advisor trying to explain to your client the differences between active versus passive and you want to provide them with a good understanding that reflects the market [and] reflects a smart way of choosing funds or choosing a portfolio management, how would you go about that?

TIM BAKER, DIRECTOR OF PRODUCT STRATEGY, SYMMETRY PARTNERS: It’s such a great question, because it’s just getting more and more difficult. We talked a little bit about three years ago you knew who your ETF providers were. It was Vanguard. It was iShares. It was State Street. And you know, PowerShares has grown a lot, and WisdomTree has come along. But now it’s like all of these people that you think of as like active managers, hedge fund managers — Goldman Sachs is an ETF provider now, J.P. Morgan. You know, Franklin Templeton has just announced some new ETFs.

As you’re going through the space, whether it’s passive or active, how are you evaluating these funds? Do you understand the total costs involved with an ETF? It’s not just an expense ratio — there’s a bid-ask spread, just like a stock. And there’s securities lending, and there’s all kinds of costs. Whereas with a mutual fund you just get executed an NAV at the end of the day.

But where it gets more complicated — right, if I’m an advisor and I say, I’m not going to use active management anymore. I’ve given up. This manager is charging me 80 or 90 basis points a year. They underperform the benchmark every year. My clients are asking — I can’t keep defending it to my clients. I’m just going to go by the S&P 500. That’s easier. You can basically go SPY, VOO, or IVV. And those are State Street, Vanguard, and iShares’ S&P 500 ETFs, respectively.

But when you say, I believe in these factors and I want to use them to replace what my active manager — right? There’s large cap value managers out there. Value is a factor. I can go buy that factor for much cheaper than what that active manager is doing, and I’m probably going to get about the same return stream and about the same relative performance over time. Why wouldn’t I go buy that thing?

Here’s the problem — what’s value? Is it price to book? Is it price to earnings? Price to sales? Price to — I could literally sit here for 10 more minutes rattling off ways to measure value. Take that to quality — is it just profitability, gross profitability? Is it net profitability? Is it return on equity? Momentum — is it just price momentum or is it fundamental momentum? Should there be something in a company’s financial statements that indicates momentum, not just the stock behavior? That, to us, and we’re in this kind of perfect intersection of like we’ll help you evaluate the universe.

We’ve also been doing factor investing for about 15 years now. So we’re not going to tell you we’ll identify the best value of factor, we’ll identify the best value of momentum, because it’s like everything else. Take this momentum fund and this momentum fund — they’re going to do different things at different times based on how they measure momentum. Same with value. I had a conversation with an advisor who was — we were having this healthy debate about whether or not momentum is really a good factor and is it going to change and I shouldn’t really be using it.

And I said well look, what we’re having here is not an academic disagreement. We’re having a philosophical disagreement. I can’t predict which measure of value or which measure of momentum is going to do better next year versus last year. I just don’t know. My job is to go find something that gives us good exposure to that factor, and then stick with that and not try and outguess — which is what active managers have been trying to do for years.

BRUCE LOVE: Thank you very much Tim.

TIM BAKER: Thank you. Appreciate it.