Morningstar's Davidson: The active vs. passive misnomer

Contrary to the adversarial nature of the active versus passive debate, there is room for both in a portfolio, according to Lee Davidson, senior quantitative analyst at Morningstar Inc.

[MUSIC] Active versus passive has been a debate for a lot of years. And it often gets the, you know, it's an adversarial relationship when you put active versus passive, right? When you're talking about role in portfolio, maybe there's only one solution you want to go with. And I think that's a misnomer. Most of the experts think that there's a role for both active and passive. Some in the portfolio and the specific you know, the key thing is to have a decision framework that you can take away with you to different subsectors and asset classes to ask yourself, and answer the question for yourself, when do I go active versus when do I go passive? So if you're thinking about, how do I identify specific sector? . The first thing you do is you want to do some sort of returns based. Analysis. So, look for differences in outcomes and risk adjuster returns and managers and maybe larger blend, small value, international small cap, international emerging market. Fund manager. So you're looking for differences in outcomes amongst these managers, so maybe you're using return differences above a benchmark. Maybe you're using alpha after adjusting for the risk exposure of that manager. And what you really want to see is, the, the categories where you want to go active are categories where managers have a preponderance of beating that benchmark. So maybe instead of 10% of the managers underperforming, the benchmark you see, 90-percent of the managers underperforming, that would be a category you'd wanna avoid. If the managers, 90-percent of them were outperforming the benchmark, that'd be a category you'd say okay, I have a higher probability as an investor to to pick a fund manager that's gonna perform better than the benchmark. So let's say that you've identified a sub-sector of the fund man, fund universe. Fun manager have a higher probability of out performing the benchmark. So let's use the international small cap, as an example. Smp just had a report that said, over the past 5 years 90 percent of the managers have outperformed their benchmark. So, you identify that category, right? But past performances and indicative future results, so whats the next thing you wanna bring to the equation? The next thing generally is some sense of this fun manager is not gonna be a closet index. You wanna, you wanna identify if he's actually gonna deliver you some active risk, some active share. Otherwise you're better off just going with a passive fund anyways. So you wanna see, is he taking bets different than the index, that might be something like an active share metric. Is his return stream different from the index. you might wanna look at R squared. So some of these metrics I think are useful to identify the specific manager. In terms of should this be a tactical or a strategic allocation, I think that these can be long term strategic allocations but the areas in which active managers tend to perform better than the benchmark will change over time as different markets become more liquid and more transparent. Competition enters, erodes some of their their skill so you want to be flexible, maybe reevaluate these positions and be a little bit more diligent than you would be with just a passive [UNKNOWN]. It takes a good amount of due diligence on the part of the advisor to identify the funds that may or may not outperform the benchmark to even give themselves a good probabilistic. It's the chance of doing so. And so that's one of the biggest downsides from go- for going active versus passive. Passive, you set it; you forget it. Maybe you go with a strategic beta product that you al-, but you also need to reevaluate that like you would an active manager, cuz those can go out of favor as well, so.

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