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Active Or Passive? What Investors And Advisors Need To Consider.

Actively managed funds or index funds? It’s a common question that many investors and their advisors confront during portfolio construction. Is it really that simple, or are there other factors to consider?

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Dan Berkowitz is an investment analyst with Vanguard Investment Strategy Group. We interviewed Dan about what advisors and their clients should weigh when they’re deciding which type of investments may give them the best chance of achieving their financial goals.

Before we dive into the recommendations for portfolio construction, why don’t we take a step back and talk about how Vanguard defines active and passive investments.

Dan Berkowitz: Many folks in the industry do use these terms slightly differently. And there is no one right way to define them, but it’s, obviously, helpful context for our conversation here today.

And so, from Vanguard’s perspective, we consider passive to be broad-market-cap-weighted indexing. And then, so an active investment would be any tilt off of a broad-market-cap-weighting scheme.

And by tilt you mean what?

Dan Berkowitz: Any investment that uses a weighting scheme or construction that is different than broad-market capitalization.

So can you give us an example of something that people might think was passive, but we would consider more active?

Dan Berkowitz: Yes, it’s a good question. And, honestly, this used to be an easier discussion for us when market-cap-weighted indexes primarily were what was out there in the indexing universe. But what we’ve increasingly started to see is, these lines blur between active and passive. And a great example of this is the growth of the fundamental indexing category, or that smart beta category, where now active decisions around fundamental characteristics that you can use to weight securities are being baked directly into index construction and index methodology.

And so, while these may be index funds or ETFs, we would by no means call them a passive option based on the definitions that we were just talking about. And so herein lies the challenge for us in that it’s become increasingly difficult for us to take a look at an investment option as a stand-alone and say, this is active, or this is passive. We think that investors just need to do a bit more due diligence, really, and look under the hood.

Now, in recent years, we’ve seen many investors moving out of active funds and putting money into index funds. What does our research show?

Dan Berkowitz: Yes, so what we think describes recent trends more accurately is, actually, high cost versus low cost and so, more specifically, dollars flowing from higher-cost products to lower-cost products. And we see this trend reflected in industry cash flows.

And interestingly, if we disaggregate the industry cash flows—for example, in the U.S. equity universe—into active and passive categories, we would see the same trend in both pieces. So dollars flowing into lower-cost active products and dollars flowing into lower-cost passive products are typically at the expense of higher-cost products in both of those categories.

What do you think’s driving that?

Dan Berkowitz: So regardless of whether we label something active or passive, we think that investors are becoming increasingly discerning when it comes to factoring cost into the investment-selection process. And this is something that we love to see because we know how critical low costs are to achieving investment success.

Read the full article here by Dan Berkowitz of Vanguard, Advisor Perspectives

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