Morningstar Advisor - August/September 2011 - (Page 52)

Morningstar Conversation You take all your active managers in the world and add them up—they are the market. So, you’re going to get the market. And if you take all your index managers and add them up, obviously you get the market as well. And then the sole difference is, What are the implicit and explicit fees that go along with that? And that’s why indexing over long periods of time tends to outperform active management, because at the end of the day active management is a zero-sum game. Now, one could argue and say, well, it doesn’t have to be a zero-sum game, because there aren’t two constituents; there are multiple constituents out there. There are individual stock shareholders who are getting crushed by the active managers. So, it’s actually possible to consistently beat the market. But I think individual ownership of equities has shrunk very dramatically. And, again, the data all supports that when you add up all your active managers, it looks like the market minus the costs. You guys have actually done some fabulous work on that over the years at Morningstar. A fundamental strategy does not guarantee that same kind of result, because it is, by definition, a set of factor bets. And we’ve lived in a world where small-cap— and small- and mid-cap in value—have been outperforming for a pretty prolonged period of time, so those factor bets have really paid off. But they are just that, they are factor bets. In the long run, when we go through a full cycle, there will be a period of time where growth and large cap actually do outperform again, and I think there’s going to be a lot of disappointment [with fundamental indexing]. Flanagan: We do have three active ETFs. If you look at the amount of conversation [about active ETFs] you would think there’s a trillion dollars in active ETFs. The concept really has not taken off in the marketplace. That said, I do think there’s a place for them. Where we have taken them to the market is fixed income, quantitative equity, and real estate. It is not going to take over the world. I think it is probably not an appropriate vehicle for lots of equity investing. The fundamental idea that an active manager has to publish their portfolio every day, I don’t think it’s in the client’s best interest as they’re building those positions. So, it will evolve. It will probably have a place. I just don’t see the revolution around it that has been declared, personally. McNabb: I would second all of that. Again, if you step back and think about how we’ve created ETFs, in theory, we could add a share class to any of our active funds. In a sense, I could make the exact same argument to you that I made about our index funds. We want the product structure that works best for the end client, and we don’t really care whether it’s a traditional open-end fund or an ETF. client. What’s their investment horizon? What’s their risk tolerance? What are their liquidity considerations? This, I think, often gets missed in this whole alternative conversation. If you go back through the crisis—and this tends to be more applicable to the institutional world—everybody was so absolutely enamored with alternatives. And you saw some foundations and pensions just get literally humbled and found themselves in very difficult situations because they extrapolated returns of “alternatives” that were very illiquid. No one thought that tail risk would ever come. And so I think, yes, you can get some attractive returns. But it is not the be-all and end-all. There’s a level of sophistication and all the other fundamentals you have to consider when you’re looking at them. I think for some people it’s just not appropriate at all. McNabb: We continue to look at it, and I think some investors moved to alternatives because they were intrigued by the perceived higher returns. From our perspective, the whole value of nontraditional investments is their diversification effect. Every active manager I talk to on our equity side is extremely concerned about what it would mean to their portfolio and how people would react to seeing it published each and every day. They really feel that they’d be giving up quite a bit of their advantage. Many of our active fixed-income managers feel the same way. We filed for an active TIPS ETF, because, frankly, in the TIPS market we shouldn’t be trying to add a lot of alpha. (laughter) Even though the strategy is technically active, there are no trade secrets in that marketplace. Culloton: What is the role and what are the perils for alternatives in portfolios? We’ve been looking for ways to further diversify portfolios without giving up too much in return. If we can find vehicles that help us do that in a cost-effective manner, we’re interested in it. Hence, the experiment—by the way, not with other people’s money, but with an internally managed portfolio—with what we’ve been thinking about for the managedpayout funds. But the more I study this space, and the deeper we get, the more skeptical I am that there are many great answers out there. Flanagan: When you hear people say, “I’m a hedge fund investor,” it gets back to this vehicle conversation. Who cares? Vehicle has nothing to do with meeting an investment need. I think really understanding what you’re trying to accomplish matters a great deal. K Dan Culloton is an associate director of fund analysis with Morningstar. Actives and Alternatives Culloton: Both of your firms offer active strategies and passive strategies. Is there a future for active ETFs? Could you see your firm pouring more of your active strategies into ETFs? Flanagan: Well, we have alternatives; right now real estate is our biggest alternative, direct real estate in particular, then distressed private equity investing through WL Ross. I think you have to step back and say, This is a 52 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011