By Rusty Vanneman, CFA, CMT, CLS Investments Chief Investment Officer

Active management has had a bad rap in recent years, but I expect the winds are beginning to change and a period of improved relative performance lies ahead. There are five winds to note: Two are heavy headwinds lessening in strength, and three are seasonal headwinds set to become tailwinds.

Defining Active Management

First, what exactly is active management? And, what is all the fuss about “passive versus active” management that generates so many headlines and articles?

In my opinion, there is too much chatter and ink spilled on the “active versus passive” debate and thus a lot of confusion among investors. There are a few topics here rolled into one — the most significant being the move from actively managed mutual funds to ETFs. It’s a complex subject, and I believe understanding can be clearer if we are all on the same page, first regarding how the terms are defined.

Passive management refers to portfolios that aim to match the return of their underlying benchmarks. Success is defined as matching the benchmark’s return (to get a little technical, the fund would have no “tracking error” if the benchmark’s return was matched). That means a passively managed fund that outperforms its underlying benchmark could be a poorly managed fund. The decision-makers on the fund are passive in making judgments about the markets and their future direction and officially have no view on market risks, fundamentals, or valuations.  Nearly all passive funds underperform their benchmarks due to expenses.

Related: Strategic Versus Tactical Asset Allocation

An active fund, however, aims to outperform its underlying benchmark. Success is defined as achieving a higher total or risk-adjusted, return over time. Managers make active decisions about where the market presents opportunity. Instead of being like the benchmark, they are trying to be different. While more actively managed funds beat their benchmarks, it is important to note the average actively managed fund has historically underperformed the average passively managed fund in terms of total returns. We will dive into those reasons later.

The next key item to determine when referring to passive or active portfolios is whether the subject is the overall investment portfolio or the underlying holdings of the investment portfolio.

At the overall investor portfolio level, I would argue all investor portfolios are actively managed. There must be some judgement on how a portfolio is allocated based on the investor’s objectives, constraints, investment universe, risk tolerance, and many other unique considerations. To be truly passive, one would simply always own the global market (both stocks and bonds), and that is rarely the case. Thus, being “active” is a good thing for investors. Decisions do need to be made.

The active versus passive debate becomes more significant when reviewing the ingredients or underlying holdings that make up investor portfolios. In this case, active and passive funds are both fair game. Some investors prefer active management; some prefer passive. At CLS Investments, we use both. It just depends on the situation.

In general, active management strategies have underperformed passively managed strategies. While many studies show active professional money managers usually add value — before fees and adjusting for cash holdings — the net return experience for investors has generally favored passively managed funds, especially during the current bull market.

Related: Do Active ETFs Outperform?

Despite this track record, we think active management will perform better in the years ahead in terms of relative performance. There are two ways to measure this.

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