Advisors Using Active Strategies

The choice to use active strategies often comes down to client needs and the benefits of customization.

Reviewed by: Debbie Carlson
Edited by: Debbie Carlson

[This article appears in our July 2019 issue of ETF Report.]

This may be the year that passively managed funds garner half of the U.S. equity fund market share.

Morningstar data shows that as of the end of 2018, U.S. equity funds represent 51.3% of market share versus 48.7% for their passive counterparts, and Morningstar expects the market share to even out between the two in 2019.

The trends may be solidly in favor of passive strategies, but not every financial advisor is joining Team Passive. Advisors who use active management strategies say they prefer them to passive for their high net worth and retired clients. Some like to use active strategies to capture outperformance, while others say active management can mitigate downside risk.

These advisors also believe active strategies still have the edge in certain markets, such as in fixed income, international markets and small cap stocks. It also doesn’t mean these financial advisors completely shun passive strategies. They may use them for younger clients accumulating wealth or those with smaller accounts. They may also use passive strategies as a complement to their active strategies.

Client Needs
The No. 1 reason a financial advisor may choose an active strategy over passive comes down to client needs, say financial advisors who spoke to ETF Report. For high net worth individuals, active strategies suit their needs, says Mark Painter, president of EverGuide Financial Group.

“A high net worth investor may have different goals for different pieces of money,” he said. “It’s not simply somebody that’s saving toward retirement or saving toward buying a house or any particular goal.”

There may be business needs and individual needs, or trust accounts for children and grandchildren: “Having that customization makes sense, because there are a lot more tax issues that come into play.”

Brian Pirri, principal at New England Investment & Retirement Group, says when diversifying investments for high net worth individuals, some passive choices may not be suitable or aren’t available. He says his firm not only uses the traditional mix of stocks and bonds for these individuals, but real estate and alternative investments, looking for vehicles that aren’t correlated to the overall market.

“So obviously we’ll go active on that stuff,” he said.

Painter says he’ll also use active strategies for retirees who often need very customized situations regarding income needs. He prefers to use a mix of stocks, bonds and real estate to create a reliable and sustainable income stream while participating in potential upside to protect against inflation. Painter says this would be “very difficult” to reproduce using passive strategies.

“You can do this with a mix of dividend ETFs and other income-producing ETFs, but from a perspective of really knowing your risks and having visuals on individual holdings, it makes a big difference,” he said.

While ETFs have daily transparency as part of their structure, some financial advisors who use active strategies prefer to be able to explain to clients exactly why they hold specific securities.

Peter Johnson, CEO of Ashfield Capital Partners, who favors picking growth-oriented stocks over a market cycle to outperform benchmarks as part of the firm’s core strategy, says his high net worth clients also like knowing what they’re holding and the specific reason for each security.

He says their active strategy lets them control the risk/reward characteristics of a portfolio much more easily and to customize it around the particular client’s goals and objectives. That’s especially true for clients with socially responsible investing wants.

“Clients like to know they don’t own a tobacco stock, or that they own environmentally [friendly] stocks if they have an emphasis in their portfolio around causes and beliefs they have,” Johnson said.

Sector-Specific Needs
Pirri says his firm uses active managers when it comes to investing outside of the typical U.S. large cap equity sectors. In international investing, he chooses active managers who have the ability to buy stocks or bonds that aren’t included in an index. But he’s also selective, looking at active managers with long track records of outperformance. The same goes for small cap active managers, he says.

Fixed income is another popular asset class in which to opt for active strategies. Painter and Pirri say active management in fixed income is superior, since it can much more easily outperform the benchmark Bloomberg Barclays U.S. Aggregate Bond Index.

For Painter, again, it comes down to customization for retired clients. He says he can stagger maturities for a client who needs a certain amount of income in the next few years versus a client who needs consistent income, allowing him to arrange maturities differently.

Ashfield’s Johnson says active strategies let him take advantage of market dislocations or overreaction to near-term trends in a way passive ETFs can’t. He says the amount of money that’s going into passive investing is actually “creating some opportunities for arbitrage.”

Johnson used retail stocks as an example, noting there’ve been significant valuation divergences between pure online retail operations with no physical presence and brick and mortar retailers that are trying to pivot to online shopping to augment their physical stores.

“There’ve been opportunities to own shares in businesses that are going to perform well in the long term, but in the near term, they’re undervalued, in our estimation,” Johnson said.

Health care is another area where he thinks stock picking is superior. Ashfield is overweight health care stocks versus the benchmarks, but the firm is focused on companies specializing in cost containment, information technology and medical devices. The only time Ashfield uses an ETF for its health care holdings is when using an equal-weight biotechnology ETF, at a 3% weight.

“It’s a good example of where an ETF can be complementary to a core [stock-picking] strategy, because biotechnology is a subsector that’s relatively young, has high growth, but high risk and a lot of failure,” Johnson noted.

Risk Management Advantage
The financial advisors had different views on how well active management does in giving outperformance or ensuring risk management. Painter says active management strategies for his retirees are to provide steady income and maybe a little upside during rising markets. If he uses ETFs, it’s as a risk management tool, an overlay to the active management.

“If I’ve set income goals and need to have stocks to reach those income goals, and things are difficult like they currently are, I can—depending on the situation—buy put options or short the S&P 500 to reduce my overall market risk,” Painter explained.

Pirri thinks active management can reduce drawdown during volatile swings, noting that an active manager has the ability to get more defensive, whereas a passive index can’t change direction. “If you’re sitting in a passive index in a drawdown period, you’re going to get killed,” he said.

Market conditions may also make active preferable to passive, Pirri says, noting that from 1999 to 2009, passive index returns on the S&P 500 were lackluster, whereas in the bull market of the past 10 years, passive has performed well. Times might be changing again.

“In periods of more volatility and when the market gets long in the tooth like now, that’s when you see active management really take over,” he said.

Debbie Carlson focuses on investing and the advisor space for U.S. News. She is an internationally published journalist with bylines in publications including Barron's, Chicago Tribune, The Guardian, Financial Advisor, ETF Report, MarketWatch, Reuters, The Wall Street Journal and others.