Where to go active?

Christine Benz: Hi, I'm Christine Benz from morningstar.com. In what parts of the market are you better off sticking with passive products, and where is it reasonable to use active funds? Joining me to discuss that topic is Alex Bryan. He's Morningstar's director of passive strategies research for North America. Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, you recently delved into this topic in ETFInvestor, and your headline takeaway is that it's perfectly fine to go all passive with your portfolio, but you did call out some parts of the market where it's reasonable to use active funds. And so one of the key areas you talked about was if you're looking at a market segment where the benchmark is not representative of what active investors are doing. And you called out the Bloomberg Barclays Aggregate Index as an index that isn't necessarily representative of what core intermediate-term bond fund managers are doing. So let's delve into that.

Bryan: Sure. So if you take a look at the composition of the Bloomberg Barclays Aggregate Bond Index, it tends to be quite a bit more conservative as far as its credit risk goes than most active intermediate core bond managers. So about two thirds of that portfolio is parked in U.S. Treasuries and agency mortgage-backed securities, so it doesn't take a genius to figure out that if you take more credit risk than that benchmark, you can probably beat it. And that's in fact what a lot of active managers do.

Now, if you consider the counterfactual--let's say if you imagine that the aggregate bond index looked a lot more similar to how active managers in the category invested, it would be harder to beat because if an index is representative of its active peer group, the gross of fee performance between the two should be similar and the main driver of the difference would be the difference in fees. So the more similar an index is to its active peers, the more important fees become and the more confidence that you have that low fees will translate into strong category-relative performance. But where there are some differences, as is the case with the aggregate bond index, differences in fees may not be enough to get you better category-relative performance.

Benz: So, it's not as if you're saying this is an area where definitely use an active fund. In fact, we're seeing a lot of investors buying total bond market index products, and you think that's a perfectly OK way to play it. But this is also an area where it's not unreasonable to use an active fund.

Bryan: That's right. So the payoff to credit risk isn't a free lunch, right? It is a real risk. Active managers who take greater credit risk have greater potential losses if the economy turns south. So that's a real risk. The other thing that I think a lot of people overlook is that the payoff to credit risk is positively correlated with stocks. So if you are investing with an active manager who's taking a lot of credit risk, they may not be able to diversify your stock holdings as well as a more conservative bond index fund that favors Treasuries and agency mortgage-backed securities. So there's nothing wrong with sticking to a broad conservative index fund in this group. It's just that they may not lead the pack as far as returns go.

Benz: Sort of the classic rationale for using an active fund is that there might be certain market segments where pricing inefficiencies can crop up, and those might be the places to go active. First, do you think that's a legitimate reason to go active? And second, if you do, what would be the areas that would qualify as susceptible to those pricing inefficiencies and therefore a decent place to use an active product?

Bryan: Yeah, that's a great question. So mispricing is, I think, necessary for active managers to add value, and you would expect that active managers should do better in areas of the market where there's greater supply of mispricing. So I think the intuition there is legitimate, but it's not sufficient to lead to outperformance because if mispricing helps some managers, it also will likely hurt other managers because in aggregate, active management is a zero-sum game. So it certainly opens up some opportunities, but it's not sufficient to lead to outperformance.

Now as far as the areas of the market that likely are more susceptible to mispricing, I think that high-yield bonds or emerging-markets stocks as well as small-cap stocks are key areas where mispricing might be more common than it would be in, let's say, large-cap U.S. stocks.

Benz: Can we delve into some of those and talk about why pricing inefficiencies crop up? Maybe start with high-yield and talk us through why we do tend to see some of those mispricings and why maybe active managers can work OK.

Bryan: Yeah, so one of the key issues here is a lot of these securities in the high-yield bond market, as well as small-cap stocks, they tend to be a little bit less heavily traded, so there are fewer investors following these securities. That means there's less competition to price these securities. So with fewer managers keeping track of what's going on with the fundamentals of the issuers of those bonds or the stocks in which they're investing, there's a greater chance that the prices of those securities may not fully reflect all the information that's available to the public. So that can open up some areas where some securities might be mispriced. Competition is really what's necessary to bring prices close to fundamental value. You need competition among a lot of well-informed investors, and areas of the market where there are fewer investors competing are good candidates where mispricing might crop up here and there.

Benz: What would be some other sources of mispricing?

Bryan: Yeah, so there are some other frictions in the market that can lead to mispricing. So, for example, a lot of investment-grade bond managers are not allowed to hold anything that's rated below investment-grade. So, when you have an investment-grade bond that's downgraded below investment-grade, that creates a lot of forced selling pressure, and that can cause these types of bonds, so-called fallen angels, to become undervalued. In emerging markets, you have other constraints like limits on foreign ownership and limits on shorting stocks in certain markets that can also act as a hindrance that prevents efficient price discovery. So there's a combination of different things, but I think, just to summarize, small-cap stocks, emerging-markets stocks, and high-yield bonds are areas where these frictions crop up a bit more than other areas in the market.

Benz: So maybe more opportunities for active managers in some of those areas, but it's still important to keep an eye on costs, right? No matter whether you're going with a passive product or an active product.

Bryan: That's right. In order to get back to even, active managers have to recoup their fees. The lower the fee hurdle that they have, the easier the task so fees are always important.

Benz: So small cap, EM, high yield, those would be some areas to potentially consider using an active product. Let's talk about some areas where investors should definitely go passive--that the data and everything else we know suggest the advantages accruing to very low-cost passive products.

Bryan: I would be very careful with saying "definite" because very few things in investing are. There are a good active managers really in all categories, but I think the odds of outperforming in large-cap stocks are not quite as good as they are in some of those other areas of the market that we talked about.

So large-cap stocks are a really good candidate for index funds because these tend to be areas of the market where the index is a representative of how active managers invest. Index funds charge a lot less than their active counterparts--that works to their advantage. These are also areas in the market that are highly competitive, where there are a lot of well-informed investors who are competing against one another, driving prices toward their fundamental values. So it's very difficult for active managers to consistently outperform by identifying mispriced securities.

So I think all those things really work in, in favor of index funds in these highly liquid, highly competitive large-cap stock markets, both in the U.S. as well as in foreign developed markets as well.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.