Morningstar Magazine - June/July 2017 - 34

Spotlight: The Future of Investing

Passive Itself Is Getting More Active

Not only are investors making active use of passive
funds, but the complexion of passive funds is also
changing. Asset managers are looking to marry the
best traits of active and passive, pairing active
bets with the strict discipline and lower costs of an
index approach (E X H I B I T 4 ). This has given rise
to a swelling number of strategic-beta (aka "smart"
beta) ETFs and substantial growth in these funds'
assets. From the launch of the first generation of
these ETFs in 2000, their collective AUM had grown
to $556 billion as of the end of 2016, having

compounded at an annualized rate in excess of
40% during that period ( EXHIB IT 5 ).
These funds make rules-based active bets against
the market in a nominally passive manner.
Unlike traditional actively managed funds, there is
no ongoing research or day-to-day buy, sell, or hold
decisions made in response to developments in
the markets. As these are active bets, these funds
give investors the opportunity for outperformance,
less risk, or some combination of the two relative
to owning the market at large via a broad-based

EXHIBIT 4

Best of Both Worlds Strategic beta attempts to marry the best traits of active
and passive.
Market Capitalization
Weighting

01/1994-03/2017

Passive Trailing 12-Month

Passive Implementation

Passive

Estimated Net Flows
+800
USD Bil
+643.7
Strategic Beta

Active

Rules-Based Active
Screening/Weighting

Passive Implementation

+400
Active

Active Implementation

0
-267.9

Source: Morningstar.

-400
1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

EXHIBIT 5

Smart Growth Strategic-beta ETFs have grown substantially since the first
generation was launched in 2000.
Assets Under Management

Estimated Net Flows

600.0
USD Bil

70.0
USD Bil

450.0

52.5

300.0

35.0

150.0

17.5

0.0

0.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Morningstar.

34

Make no mistake, strategic-beta and other kindred
factor-focused approaches to portfolio construction
are a form of active management. So, not
unlike traditional active funds, not all of them will
succeed in generating better risk-adjusted returns
relative to plain-vanilla market-cap-weighted index
funds over the long haul. And like the best active
managers, these funds will experience cycles of
performance marked by droughts and marketbeating returns. As such, investors' patience will
be tested, and their behavior may be suboptimal.
We have already seen examples of all-too-familiar
performance-chasing behavior among investors in
these funds. The active decisions that matter most
are still those made by the end investor.
I'm Not Dead

Rules-Based and/or
Discretionary Active
Screening/Weighting

1994

market-cap-weighted index fund. It also takes an
important risk off the table-manager risk.
Omitting the uncertainty associated with the
human element of active security selection is an
important differentiating feature. Furthermore,
because these strategies are delivered via an ETF,
they can be more tax efficient than traditional
active funds. Most important, however, is the fact
that these funds tend to charge lower fees than
most of their active peers.

Morningstar June/July 2017

Active management will never die. It will continue
to evolve-we hope for the better. Fees will face
pressure, and fee arrangements themselves may
also evolve. Performance fees and loyalty programs
are among the ideas being mulled by fund
sponsors. New share-class and product types are
also coming to the market.
Active managers may also get more active. The
exodus from actively managed funds has
disproportionately affected funds that are highpriced benchmark huggers. Taking on more
active risk is the only way that many managers
can possibly justify their current fee levels.
The movement to passive and the growth of
strategic-beta and other factor-oriented funds will
drive the evolution of active managers and further
reinforce the fact that active and passive are
becoming more indistinguishable by the day. K
Ben Johnson, CFA, is director of global ETF research with
Morningstar Research Services and is editor of Morningstar
ETFInvestor. He is a member of the editorial board of
Morningstar magazine.



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