FA Center: These markets are where advisers should consider active management

Traders on the floor of the New York Stock Exchange on March 2, 2017.

Investors’ desire for lower-cost advice and a lack of affordable quality advice for consumers seems likely to drive more assets — and headlines — to robo advisers. However, there’s a balance to be struck between costs and results, and advisers should consider active managers for at least a portion of clients’ portfolios.

Many robo advice offerings use only passive funds, mainly exchange-traded funds. Clients complete an online questionnaire designed to assess their risk tolerance, then receive one of perhaps seven risk-profiled portfolios. This lets them invest relatively inexpensively, with low fees for the advice and the products.

Passive-only portfolios may not always provide investors with the best possible outcomes in the coming years. We’re unlikely to see a repeat of the high returns of the past eight years, so good asset allocation alone may not provide clients with the returns they require. Portfolios dominated by equities, credit and government bonds will likely offer a less attractive risk/return trade-off for the foreseeable future.

Beverley Sharp

Furthermore, offerings utilizing traditional market-cap benchmarked passive products have their own drawbacks. Market-cap weighted benchmarks are subject to flaws and inefficiencies: The MSCI World Index, for example, was comprised of over 26% in financials going into 2007, a large concentration of risk immediately preceding the global financial crisis. It bottomed at 16% in September 2016 before a recent rally in the sector.

Where passive investment is desired, consideration should be given to so-called “smart beta” indices designed to eliminate some of these inefficiencies. While not exactly passive, smart-beta products offer access to systematic strategies, generally at lower fees than actively managed funds.

Active management, meanwhile, provides an opportunity to achieve a diversified return source, improved returns and lower risk. It should be considered as an option for allocations to less efficient markets where there is an opportunity for investment managers to better forecast results and pick outperforming securities.

Read: Wall Street pushes active management, but investors aren’t biting

Consideration obviously needs to be given to the costs and the probability of achieving their objectives: Do the possible returns, in short, justify the fees?

The tables below show which markets have historically demonstrated opportunity for outperformance. Our analysis indicates that markets such as small cap equity and high yield fixed income have yielded opportunity for outperformance, had a better-than-median investment manager been selected.

Median managers have underperformed the benchmark after fees in U.S. large cap and U.S. government bonds by some margin, depending on the time period assessed. This isn’t to say that a good active manager cannot outperform in those markets, but the bar is higher.

Read: Investors tap investment-grade bond ETFs

Looking ahead, asset classes that are broad, under-researched and diverse should be the main focus of active management efforts.

Clients might be happy with passive-only portfolios during bull markets, but how long will they be remain happy when markets are less rewarding? And what will drive their decisions long term: low costs or the total return of their portfolio?

Advisors may prefer to use a mix of active and passive strategies, balancing risk, returns and cost considerations. They should consider using low-cost passive strategies or smart beta in more efficient markets where outperformance is harder to come by, and reasonably priced active management in markets with higher potential.

You’re invited: MarketWatch is hosting a free panel discussion on the future of robot — and human — financial advice on April 5 in downtown Boston. RSVP required, continuing education credit available. Learn more.

Beverley Sharp is global head of retail research at Mercer, a global wealth management and advisory services firm.

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