Index funds gain in popularity, posing challenges for Legg Mason, T. Rowe

Passive management a 'Jesus, take the wheel' approach to retirement investment, expert says.

Investors are increasingly riding the rise of indexes, which poses challenges for Baltimore companies like T. Rowe Price and Legg Mason that count on promoting their ability to pick stocks.

As markets have risen in recent years, investors have flocked to funds that mirror indexes like the Dow Jones Industrial Average or the S&P 500 and captured those gains. Meanwhile, investors have pulled money out of actively managed funds of U.S. stocks every year since 2006.

Against those head winds, some money management companies are offering new kinds of products.

Legg Mason has been offering "next generation active" investments in esoteric alternatives like unconstrained fixed income, absolute returns, real assets, or infrastructure. While the company's primary business is still in actively managed funds, executives say they want to offer an array of options.

"Really, the combination allows us not to just survive in the business but to grow," said Tom Hoops, Legg's head of product and business development.

Other money managers have hewed to pushing their actively managed portfolios. While investing in index funds might be attractive in a boom year, they argue the investment expertise of a professional can be invaluable in a downturn.

"It's like flying a plane yourself, or hiring an experienced pilot," said Jonathan Murray, a financial adviser at Hunt Valley's UBS Financial Services. "I think wealthy people want to protect in the downside. Why own Greece when you don't have to? Why own China when you don't want to deal with the risk? A passive index throws all that into your bucket."

Actively managed funds still dominate the market, with more than $11 trillion invested compared to about $2.2 trillion in index funds, according to the Investment Company Institute, the Washington-based research arm of U.S. investment companies.

But investors pulled $52 billion out of actively managed funds in 2014 and $16 billion as of May this year. At the same time, investors plowed $148 billion into index funds in 2014 and $94 billion as of May.

Active management, in which advisers pick stocks or other investments for clients, is still popular, and firms specializing in it are still profitable.

But critics, especially after the Great Recession that hammered stock markets, have questioned the strategy. Actively managed funds have been criticized for their performance and high fees that eat away gains.

That has fueled the popularity of index funds.

"It's partly because the active Wall Street universe lost credibility, and I think more investors said, 'You know what, I don't have control when I give my money to someone else to manage,'" said Yuval D. Bar-Or, an assistant professor at the Johns Hopkins Carey Business School.

About 86 percent of active large-cap fund managers failed to beat their market benchmarks in 2014, according to the S&P Dow Jones Indices score card. And fees for actively managed funds can be as high as 1 percent or 1.25 percent, compared to as low as 0.2 percent for index funds.

The $45.4 billion Maryland pension system for state employees has come under fire in recent years from the Maryland Public Policy Institute for the high fees it pays to have its funds actively managed — $329 million in 2014 — while the system's investment gains have underperformed compared to other large public pension systems.

The conservative-leaning think tank has urged the state to switch to index funds to save money and boost performance.

Mark Johnson, an assistant professor of finance at Loyola University Maryland, said he relies on passive investment for retirement "just because I know how hard it is to beat the market."

Mutual fund companies "have the best and the brightest managing these funds, but it's hard to beat the benchmarks and they know that. I compare passive management to a 'Jesus, take the wheel' approach to retirement investment."

Both Legg Mason and T. Rowe offer a small number of passive management strategies for clients, though the core of their business is in actively managed funds.

Nearly 90 percent of T. Rowe's funds outperformed the Lipper average for the one-, three-, five- and 10-year periods. Legg Mason reports that 92 percent of its assets under management beat the Lipper benchmark over the past decade.

Both companies are profitable and have seen a rise in the amount of client assets they manage. In May, Legg had more than $700 billion in client assets under management and reported a 20 percent jump in first quarter earnings. T. Rowe, which manages about $773 billion in client assets, saw earnings rise about 2 percent in the first quarter.

The so-called next generation active investments give Legg a way to stand out with offerings that can't be duplicated with an index fund, Hoops said. Both Legg and T. Rowe also are expanding investment options in international markets.

And Legg is exploring whether to offer exchange traded funds, or ETFs, that could include index funds, Hoops said. Earlier this year the company recruited a couple of investment managers from competitor Vanguard who specialized in ETFs.

Legg recently filed with the Securities and Exchange Commission for approval to offer index ETFs and received approval several years ago for actively managed ETFs. The timeline for when it would roll out ETFs is not set, Hoops said.

At T. Rowe, executives said the company plans on sticking to its traditional, primarily active management approach.

"We certainly see cycles of demand where active or passive is more popular," said Charles Shriver, who manages the firm's global allocation fund. "Investors will continue to look for active managers who will deliver strong, long-term performance. I think we have a consistent approach and a consistent investment process that we continue to offer investors."

cwells@baltsun.com

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