Christine Benz: I'm Christine Benz for Morningstar.com.
We're talking about active and passive strategies all this week on Morningstar. Joining me to discuss how the two might be blended together into a portfolio is Russ Kinnel, director of fund research for Morningstar.
Russ, thank you for being here.
Russ Kinnel: Good to be here.
Benz: Russ, I know that you tend to believe that investors can do well with all active portfolios, all passive, or maybe a combination of the two. What are the reasons that you might want to think about blending the two strategies together in your portfolio?
Kinnel: You can use both to get you to your goal. You really want outstanding funds with a lot of similar characteristics, and it's really not that important what percent is active and what percent is passive. It's more about, do I have good funds that are going to help me get to my goals.
You really need to be a choosy investor either way, and as long as you are a choosy investor using the right measurements, you ought to do pretty well.
Benz: Before we get into some of the specifics that you might look at when picking active or passive funds, I want to talk about how investors should think of their own characteristics as investors. That may influence whether they have primarily passive or primarily active portfolios.
Let's talk about tax position. How does that play a role and how might that lead to an emphasis on passive?
Kinnel: For sure. Passive funds tend to be very tax-efficient, and therefore a particularly logical place to put passive funds is in your taxable account. On the other hand, it's probably a little less important in a tax-sheltered account. Active funds, which tend to have a higher turnover, don't pose a tax problem there, because you don't care about the capital gains in a tax-sheltered account.
Benz: If I want the opportunity, but not the guarantee, to beat the market, I may be better off with some sort of active product.
Say I look at my behaviour over the past several years, and I see I'm the kind of investor who has an itchy trigger figure. If I'm not comfortable with my manager underperforming the market for a period of time, does that argue in favour of a passive strategy as well?
Kinnel: I think so. If you're someone who, say, has gone from bear market funds to gold funds to focused funds, and keeps getting burned from that experience, then maybe passive funds are better – in particular, the really diversified, broad-market passive funds.
There are ETFs for the tiniest of niches, so you can still be an overly nervous trader, making market-timing moves with ETFs as well. But if you invest instead in big total-market funds, I think that's probably a good fit for someone who is prone to trading a little too much.
Benz: Do our Investor Return data tell any stories about whether investors in index funds tend to be a little more patient than investors in active funds, or is it a wash?
Kinnel: We've looked at the open-end side; the ETF story is really one that hasn't fully developed. On the open-end side, index investors tend to be a little more patient. We see differences by fund company; we see differences by strategy.
But, yes, they tend to be a little more patient, and certainly most people understand why you do need to be patient, so if that helps you to be a more patient investor, then that's just another reason to go passive.
Benz: If someone has decided they want to make room for some sort of active strategy, or maybe several active funds in their portfolio, what are the key things they should prioritize when they are making those selections?
Kinnel: You want low costs just as you would with passive, but then obviously the manager and the strategy and how those come together are much more important on the active side. The great thing about active funds is, there are thousands and thousands of them. So you can be really picky. You can say, "I want low cost. I want a really stable firm where the managers stay and make a career. I want a really good strategy. I want a fund that isn't suffering from asset bloat."
You can put out a number of key criteria and still find a number of funds that pass all of those tests, and that will lead you to some really good funds.
Benz: Our Gold-Rated funds would tend to showcase some of the best actively managed products.
Kinnel: That's right. I would start with our Gold-Rated active funds, just as on the passive side, I'd start with our Gold-rated passive funds.
Benz: With passive products, obviously cost is one of the key considerations. What else should investors be thinking about?
Kinnel: You generally want a fund that's very diversified – I mentioned total stock market funds earlier. A lower turnover is good because, again, higher turnover indexes tend to get a little messy and end up running big trading costs. So, I look for lower-turnover strategies. And also look for ones that are proven. You can be choosy with your index funds, and one of the things you can do is say, "I want something that's got a longer track record that I feel like I can really look and understand what the risks are, what the volatility is, because it's been around for 15 or 20 years."
Benz: We've seen a lot of indications that investors are casting their lot with passive products, but it sounds like, in your view, investors really can find success with a combination of the two – active and passive?
Kinnel: For sure. I do that in my own portfolio, and you can see it reflected in our ratings as well.
Benz: Russ, thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
