Active vs Passive: What is Best for the Investor?

Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall, and I'm joined today by Vanguard's Head of Investments for Europe, Ken Volpert.

Hello, Ken.

Ken Volpert: Hi Emma.

Wall: So, we've been running an Active and Passive's Special Report Week this week, and we're looking today about how active and passive strategies can be blended together, because it's not a case of active versus passive. It's about what's best for the investor.

And the approach that a lot of investors are adopting is to have passive strategies in the core of their portfolio, and to have active management value added around the outside and these, sort of, satellite funds. I thought perhaps you could tell us a bit more about where passive is best and where active is best?

Volpert: Yes. So, passive is best for the core part of your portfolio, which is really a broadly diversified portfolio with very, very low cost, low turnover. In this day and age where liquidity is not that that good, the bid/ask spread is a lot higher which means that it eats more of the return from investors.

So actually a passive strategy is actually very appealing right now for that reason as well, not only the low expense ratio, but also the low transactions costs. So core is really where the passive works best.

Wall: And you've mentioned that cost which is the key attraction for a lot of people to passive strategies, but it's not just something you should only consider when investing in ETFs and tracker funds, isn't it? It is something you should also consider with active fund management.

Volpert: Yes. That's exactly right. I mean a lot of active fund managers on a gross basis actually do outperform. When you gross up for their expense ratios, they do outperform the benchmark, but when you take away really high costs, it actually puts them behind the trackers. So it's really important for investors to look at low-cost active if they're considering active as part of this strategy with passive.

Wall: And there can be real differentiation within the same sector. So, take U.K. Equity Income, you can have one strategy that is charging almost passive like fees and another that's charging 100 basis points more. If you compound that over time that could really have an effect on your portfolio.

Volpert: Absolutely. Yes. Very high cost funds can eat -- right now, in fact, I'm looking at the low yields in the fixed-income markets, they can eat 100% of the expected yield on the fixed-income markets, especially in Europe were yields are even lower. So it's very important for investors to look at the cost and the compounding impact and how that can hurt their returns in the long run.

Wall: And all passive funds and the rise and popularity of passive funds having a positive effect on the fees within active management, because we saw RDR which did bring down fees in UK on active management, but we're hoping for a bit more. We're hoping to have a less difference between active and passive strategies when it comes to fees.

Volpert: I think there's a lot of more talk about our active fee is too high and I think there's a recognition that active fees for the higher end of the active fee range need to come down because it's beginning more and more difficult to add that alpha, as I mentioned because the transactions costs are a lot higher. So if you have a lot of turnover in your portfolio to add value through security selection, it becomes more challenging to add that net of transactions costs. So I think you're exactly right. It's becoming a more and more of a challenge there.

One of the things that a lot of people are talking about is just active share. How active are the active funds?  And so people are saying, well, if I am going to pay a very high active fee or a reasonably high active fee, I want to make sure they're really taking active risk and they have a competency. They have the real skill to be able to select securities.

So I think those are things that investors need to look at. Do they really have skill and are they really taking enough active risk to be rewarded with that active fee?

Wall: And are there certain assets that just lend themselves better to passive investment and they're one of the ones that's often brought out as the sort of U.K. and U.S. equity market because the S&P 500 is so efficient, it's so transparent, it's the one that people most go for when it comes to passive. Are there other examples like that where you would say actually passive is the best?

Volpert: I mean passive actually works everywhere mainly because passive is basically saying if you add up all active investors you basically get the market. So if you can get the market for a lot lower cost, you're going to beat the average active manager.

So in the less liquid markets, there actually the transaction costs are greater. So passive actually works pretty well there, but that's also where security selection potentially could work to. So, if you get investors who are able to buy the right stocks or buy the right emerging market bonds, they can actually overcome that transactions cost impact if they have low cost.

Wall: So it's about finding the cheapest passives and the most skilled active?

Volpert: Yes. Passive works everywhere, but active could work if there's low fee with real competency in some of the areas where security selection is important.

Wall: Ken, thank you very much.

Volpert: You're very welcome. Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.