Active No Longer The Default

September 13, 2017

ERISA & The DOL Rule

The fiduciary-driven 401(k) world is a fertile setting for index management to grow. When advisors are fiduciaries, they are forced to make the right decision for the investor.

Due in significant part to that fiduciary status, indexes are grabbing market share in the 401(k) world like Amazon is gathering shoppers. Even top-performing active funds are being replaced with lower-cost index investments in 401(k)s.

The DOL Fiduciary Rule has transitioned the index momentum from the 401(k) world to the individual investor marketplace. While portions of the rule have been delayed, the fiduciary mindset is already in place, and it is not going to ratchet back.

Investors now will ask their advisor, “Why did you decide to spend more of my money on that active fund?” Likewise, the advisor is supposed to now have a satisfactory answer. We all know it can’t just be a star rating or recent performance numbers.

Losing Default Status Doesn’t = Extinction

Fear not: Active management is not going away as a choice for investors. In the 1970s, the default family sedan was a gas guzzler the size of a boat. Now, the two most popular sedans in America are the Honda Accord and the Toyota Camry. Sure, drivers can still buy a big gas guzzler. However, it is done as an active choice, not a default selection for lack of choice.

Active managers shouldn't be surprised. They had to expect investors would recognize they were putting on weight and eventually ask to see how many calories were in the meal.

I would encourage those active managers who argue that a healthy balanced diet (diversified portfolio of ETFs) is bad for you to rethink their messaging. Instead, focus on why certain investors may want to complement core ETF exposure by taking a risk to outperform. Las Vegas does just fine luring willing gamblers, even if the majority loses. No need to try and dispute the published odds.

Beware Scare Tactics

When someone is losing a customer, and watching business shrink, a customary reaction is to try and scare customers away from the new option.

In the area by our office, there was only one car-wash option for several years. It was a “no touch” option that cost $12-$15 a wash, and never seemed to really get my car very clean. About two years ago, a new car wash opened that allowed unlimited car washes for about $30 a month.

The new car wash has been wildly successful, for easily recognizable reasons. The reaction from the owner of the old car wash was to launch a smear campaign, highlighting that his no-touch car wash was worth the money, because the new car wash will scratch your car (even though his own research shows pretty much every car gets scratched somehow anyway).

The car-wash owner’s reaction is like the articles I read that try to scare investors about indexes and ETFs. One even referred to ETFs as “weapons of mass destruction.” As ETFs continue to gain market share, the fear is indexes will ruin investing.

While I disagree with this concept on many levels, it is easy to rebut simply on timing and degree. It will take a very long time for passive investing to have a marked impact on results. According to Vanguard, only about 15% of the global equity market is indexed. This leaves 85% invested in some type of individual stock selection.

Obviously, 85% is more than plenty to punish companies that do poorly, and reward companies that do well. Likewise, if indexes are really creating problems, active managers should quietly try to arbitrage it.

Often, ETFs get bashed simply for having innovative ideas. I was interested to see so many people write negative articles when a bank-loan ETF came out years ago, even though far more bank loan assets were already held in actively managed funds with daily liquidity.

While actively managed mutual funds had essentially the same issues, and didn’t have some of the ETF safeguards, they were given a pass in articles highlighting ETF issues.

 

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