Quarterly Market Update


Q&A with BBVA Compass Global Wealth Chief Investment Strategist Dan Davidson, CFP and BWS Investment Strategist, Anne-Joëlle Viguier-Galley, CFA

In this edition of the BBVA Compass Market Outlook, Mr. Davidson and Ms. Viguier-Galley examine the merits of passive and active investment management.

1. Passive management, including index funds and ETFs, has done very well the last five years. Why should investors consider active management now?

Certainly, the dispersion of stock market returns has been below normal for the past five years, which is a large reason that passive investing has done so well. During an extended period of time when central banks around the world pushed interest rates to historical lows by loading their balance sheets with the sovereign and other debt of their respective countries, the correlation of returns between different equity classes rose, and the dispersion of returns tightened.

In this environment, passive strategies outperformed active ones. Indeed, last year investors pulled $200 billion from active U.S. equity funds while passive equity funds attracted $150 billion, according to JPMorgan data. That phenomenon was largely driven by performance and the belief that active management is “dead”. Since 2010, on average, passive large-blend strategies have outperformed active large-blend strategies on a three-year rolling basis. However, according to the Federated OnPoint Publication, active outperformed passive from 2000 to 2009. The key distinction between the two periods was the dispersion of stock market returns.

After an extended period of time when the rising tide of global accommodative monetary policies lifted all boats, and the prices of virtually all equities—good or not so good-- rose, the financial environment may very well be transitioning to one that is more favorable to active management. That the domestic accommodative monetary policy that has been in effect for the past almost ten years is being reined in should allow more opportunities for active managers to differentiate themselves, and continue to identify companies that may outperform because they are of higher quality.

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Stock Market Returns in the Last 5 years

2. What are some of the advantages and disadvantages of passive management?

Passive investing has the advantage over active strategies under certain conditions and along certain parameters.

Competitive Pricing Driver: The passive investing model has forced more competitive pricing for both active and passive investing. John Bogle, the founder of Vanguard Funds, and no doubt the single largest influence on mutual fund pricing, invented the index fund. Mr. Bogle established Vanguard as client-owned in that Vanguard clients own the funds that own Vanguard. The framework has allowed Vanguard to continually lower investment costs to the point that, according to Vanguard.com, the average expense ratio is less than one-fifth of the industry average1.

Periods of Low Price Dispersion: As we have seen, in periods where macro factors like central bank policy are driving price, passive investing tends to prevail. The opposite is also true. In an environment where central banks and other macro factors are less influential on price, active managers have a better opportunity to outperform.

Indexing, however, is not without inherent risks. Money flows into the largest names in the index more so than the smaller names because most indices are capitalization-weighted (cap-weighted) or components are weighted according to the total market value of their outstanding shares. Every day an individual stock’s price changes and thereby changes a stock index’s value.

Cap Weighted Investing Risks: The fallacy in index investing is that it assumes that larger names will continue to outperform relative to the others. Obviously, that would not be true all the time. When two or three mega-cap names suddenly experience difficulty, investors are fully exposed to the consequences. Whereas in an actively managed situation, there is at least some opportunity for proactive fundamental research and analysis to potentially uncover the problem earlier and afford the investor some relief from the pain inherent in an index-only approach.

Cash flows are a powerful driver, and if the flows continue unabated into index funds, very little else matters because by definition, the index fund must invest the cash in shares in the percentage that they exist in the index. In certain environments, this could lead to a bubble.

We want to look at one other form of passive investing, the ETF, or exchange traded fund, and the associated risks. These funds track an index, a commodity, bonds, or a basket of assets. Unlike mutual funds, an ETF trades like a common stock on an exchange, and experiences price changes throughout the day as it is bought and sold. There are $3.8 trillion in assets in ETFs as of February 28, 2017, according to Strategic Insight. In comparison, Vanguard assets, which include some ETFs, total $4 trillion.

ETF Mortality: There is a great deal of mortality in ETFs; if they do not attract sufficient assets, they are blended into other funds or dissolved. Last year, 128 U.S.-listed ETFs and ETNs (exchange-traded notes) had their listings removed, a new closure record. Indeed, of the 2,652 U.S. exchange-traded products launched since the industry’s inception in 1993, only 1,964 remain. The “lifetime death toll” is 688, and the mortality rate is 25.9%, up from 23.3% a year ago2.

Passive investing also exists in the fixed income market, and bond ETFs have picked up large sums of investor flows. The bond indices are cap-weighted based on issuers with the largest amount of debt outstanding. We would argue that the investor may be better off owning the companies that are not as leveraged, and have a better propensity to be able to pay off their debt.

ETF Pricing Risk: ETFs also have pricing-related risks which have not yet been fully tested to any great extent, somewhat like the unwinding of central bank balance sheets that can be anticipated going forward. A couple of examples of this occurred in 2015 and 2016. Some ETFs were down dramatically at the opening bell because the ETF could not adjust pricing of the underlying holdings quickly enough. Investors who were buying that day without restrictions on trading took the losses. Exchanges do not refund investors the money lost just because there was a mispricing. This highlights the importance of a good trading strategy when it comes to ETFs.

3. What are some advantages, and disadvantages, of active management?

Active management also offers a number of distinct advantages to the investor.

Tax Overlay: Overlay strategies involve the use of derivative investment vehicles, including swaps and Treasury futures, to change specific portfolio exposures relative to the underlying holdings. For example, tax overlay management enables an active portfolio manager to better harvest tax losses or delay taxable gains on individual positions. In an index fund, an ETF, or a mutual fund, the investor is subject to the gain or loss incurred when the fund is sold in addition to any capital gain that might be distributed near the end of the year. There is no opportunity to selectively identify underlying individual securities that might present an opportunity to harvest gain or losses.

Tax-efficient overlay is key to portfolio management at BBVA Compass. When managing efficiently, it is important to note the distinction between owning the individual underlying stocks versus owning an actively managed mutual fund. When it comes to tax management, owning an actively managed mutual fund is equivalent to owning a passively managed index fund. Actively managed mutual funds may be even worse because the fund manager may have the propensity to distribute capital gains at the end of the year much more so than occurs with an index fund.

Risk Reduction: Active management for BBVA Compass is about controlling and trying to reduce risk, not just generate returns. Given equivalent returns on an actively managed portfolio and an index fund, if the active portfolio generates the return with less volatility, or lower standard deviation, then the investor has gained something and improved the compounding effect during recovery.

Downside Protection: Historically, good actively managed funds show that they tend to fall less in a down market than the equivalent benchmark. And, the less the fund declines, the quicker it is able to potentially recover. This is mathematical: the less you lose on the downside the quicker it is to recover on the upside. A 40% drop requires a 67% recovery to go back to your point of departure. Simply put, compounding is improved in a less volatile investment. Of course, this assumes that the manager has a proven downside protection investment process. Not all active managers are necessarily better than an index or ETF fund on the downside.

Less Efficient Markets: The more esoteric or less efficient the market, the better the opportunity for active management to outperform. For example, in less widely-covered asset classes such as frontier and emerging markets or small cap stocks, there is the opportunity for the investor to benefit from fundamental, active, research. We have been in an environment where large-cap equities, an inherently efficient asset class that benefits from a lot of research coverage and where it is difficult to outperform the index, have led the equity universe in terms of performance. If and when that changes, the opportunity for active to outperform is greater.

Active Share: There is statistically significant evidence that managers who maintain a high active share, which is the percentage of a portfolio that differs from the benchmark, stand a higher probability of outperforming their peers, according to a calculation created by Cremers, Petajisto, Matos and Starks in 2006. Some funds say they are active, when in fact they do what is called “closet indexing”. In other words, they do not emphasize stock selection differing from the benchmark, thus the investor often pays a management fee for something that is not worth paying.

Active Share: There is statistically significant evidence that managers who maintain a high active share, which is the percentage of a portfolio that differs from the benchmark, stand a higher probability of outperforming their peers, according to a calculation created by Cremers, Petajisto, Matos and Starks in 2006. Some funds say they are active, when in fact they do what is called “closet indexing”. In other words, they do not emphasize stock selection differing from the benchmark, thus the investor often pays a management fee for something that is not worth paying.

As with index funds, active management strategies are not without disadvantages.

Higher Expenses: There is a great deal of pressure for pricing to come down, and mutual funds do have higher expenses than ETF or index funds. Many younger clients prefer to use indexing, as they frequently have the necessary time to recover in the event of a down period. Note that a diverse asset allocation is key over the longer term. In fact, some studies have shown that at least 90% of investors’ return variance can be attributed to their strategic asset allocation3.

Periods of Low Dispersion: As we have previously discussed, active management tends to underperform passive indexing when there is low dispersion between equity returns.

4. Why is individual stock research so important?

It is the research on individual names and their valuation that keeps stock pricing honest. In blind indexing or in ETFs, there is no such mechanism. If you take ETFs to the extreme and assume that the entire market becomes totally passively managed and that there is no more research on any investment holding, then there is no longer a way to generate alpha, or excess return. If the flow of fundamental research dried up, no one would ever beat the indices and you would know nothing about individual companies as no one would research them.

5. In conclusion, what is the best solution for investors given the current environment?

“As more money moves from active to passive, exploitable opportunities for active managers increase,” according to Federated’ OnPoint publication and other sources.

Certainly, there are periods of time when one or the other may be the best solution. But in our opinion, we may be entering a period when active becomes more beneficial. Also, passive investment is evolving into a “semi-passive” investment with some ETFs having built-in screens that act as filters. In any case, solid and on-going due diligence and a diversified asset allocation are key to a sound fundamental start.

At BBVA Compass, we try to customize our model portfolios to the extent possible in a way that best fits the circumstances and goals of our clients. Sometimes that includes passive investments, and it often includes the use of active management.

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Details you need to make a smart decision

1 Based on 2016 U.S. mutual fund industry asset-weighted average expense ratio of 0.62% (excluding Vanguard) and Vanguard’s corresponding average of 0.12%. Source: Morningstar, Inc.

2 Complete List of 128 ETF Closures in 2016, by Ron Rowland | Jan 6, 2017 http://investwithanedge.com/complete-list-128-etf-closures-2016

3Studies performed by: Brinson, Hood & Beebower—1986; Brinson, Singer & Beebower—1991; Ibbotson & Kaplan—2000

BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group.

Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).