Fiduciary Corner

Fiduciary duty and the choice between active and passive

The well-recognized merits of passive investing do not mean that all index investments are prudent or superior to active alternatives in all situations

Mar 26, 2019 @ 1:57 pm

By Blaine F. Aikin

There is nothing passive about being a fiduciary investment adviser, even when it comes to making decisions about passive investing. The duty of care requires the adviser to proactively exercise the skill, prudence and good judgment of a professional when selecting investment strategies and specific investments to serve investors' best interests.

Passive, or index, investing has been in a strong uptrend for the past decade, having grown from 14% of combined mutual fund and ETF assets under management in 2005 to 37% by the end of 2017, according to statistics published by the Federal Reserve Bank of Boston. That trend shows no signs of abating. It is backed by academic evidence that most active mutual fund and ETF managers do not consistently outperform index funds net of fees and expenses.

The two most compelling reasons for passive investing are low cost and the ability to more predictably earn returns that are aligned to asset class benchmarks. The approach is firmly grounded in the principles of market efficiency and modern portfolio theory.

But the well-recognized merits of passive investing do not mean that all index investments are prudent or superior to active alternatives in all situations. The fiduciary adviser must perform careful due diligence that considers both the investment strategy and characteristics of specific investments in the context of the facts and circumstances that apply to each client-adviser engagement.

In a February 2018 Fi360 blog post entitled Do Bad Index Funds Exist?, investment analyst Michael Limbacher reported that 17.3% of index funds scored in the fourth quartile of Fi360's Fiduciary Score rankings. "While this is better than the 25% expected in the fourth quartile all else equal, it shows using 'passive' alone as selection criteria is far from a fail-safe choice," he noted.

As a case in point, in 2017 New York Life Insurance Co. settled a class-action lawsuit that alleged a breach of fiduciary responsibility by two company 401(k) plans that offered the company's own S&P 500 fund, which carried a 35-basis-point fee, when comparable index funds with single-digit fees were available.

(More: Lessons for advisers from 401(k) lawsuits)

It's not just that index funds differ one from another; each index has unique attributes to consider. A recent white paper, Active Versus Passive Investing, from Abbot Downing, an asset management division of Wells Fargo Bank, makes the point that "passive management … requires the investor to accept the configuration of the index and its holdings." The paper goes on to note: "The five FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) represented 12% of the S&P 500 index and 27% of the Nasdaq index in August 2018. That's a large concentration in a single sector."

From an even broader perspective, academics and regulators have started to explore possible implications of the shift from active to passive investing for market efficiency and stability.

An 2018 working paper from the Federal Reserve Bank of Boston, The Shift from Active to Passive Investing, concludes that "the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others" and "some of the repercussions of passive investing ultimately may slow its growth."

From a practical perspective, here are a few observations worth noting.

• Markets (asset classes and sub-asset classes) are generally, but never perfectly, efficient; the more efficient the market (e.g. large-cap U.S. equities), the more compelling the case for passive investing.

• Fees are always important. According to the Investment Company Institute's 2018 Investment Company Fact Book, 72% of active mutual fund assets are concentrated in funds with expenses in the lowest quartile.

• Active management allows greater discretion to apply investment strategies to manage risk — such as using option strategies and sector weights — taxes and other client-specific factors.

• Large investment portfolios are likely to have access to more tools and asset classes that may make active management more practical.

The overarching message for fiduciary advisers is to avoid dogmatic allegiance to either passive or active investing; recognize that the duty of care demands objectivity and an awareness that decision-making is necessarily fact- and circumstance-specific. Moreover, facts, circumstances and generally accepted investment strategies change — vigilance is required.

(More: The U.S. retirement system is far too complex)

Blaine F. Aikin is executive chairman of Fi360 Inc.


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