Passive investing is no fad, financial experts say

"For us it's diversification, diversification, diversification," said Legg Mason CEO Joesph Sullivan. "The more we're diversified, the more choice we can provide clients, the more balance we can provide shareholders."

Passive investment strategies, which aim to match market benchmarks like the Standard & Poor's 500 rather than beating them, have been gaining popularity for years.

Easier to manage, such funds typically charge lower fees, which explains part of their appeal to investors.


But as the trend accelerates, it brings new attention to how money managers with active strategies at their core, including Baltimore-based T. Rowe Price Group and Legg Mason, are responding to an investment strategy that appears to be here to stay.

"Every money management firm is having to respond to this," said David Berman, co-founder and CEO of Berman McAleer in Timonium. "It's real. It's not a fad. It's not going away."


Both T. Rowe Price and Legg Mason are feeling the pinch.

For the third quarter, T. Rowe reported growth in earnings and assets under management, and said 84 percent of its mutual funds beat Lipper averages for similar funds on a total return basis for the three-year period ending in September. Yet investors withdrew a net of $200 million, largely from the firm's actively managed stock funds. Legg Mason reported outflows of $1.5 billion from its equity funds, for a net outflow of $300 million for its July-to-September quarter, while also growing earnings and total assets under management.

Active managers, who handpick stocks they think will rise, have struggled to beat the market in recent years. Add in growing attention to the typically higher fees such managers charge, and more investors are moving their money away from active funds to passive alternatives, with their lower fees and lower risk.

With about three-quarters of invested money in the United States held in actively managed funds, the trend is more of a thorn in the side of large active managers than a destructive blow, but nonetheless they can't ignore it, experts said.

"Active management will still exist, but you'll have to do it better and you'll have to do it less expensively, and that's the pressure T. Rowe and Legg Mason and others are feeling," Berman added.

T. Rowe, Legg Mason and dozens of other money management firms rely on portfolio managers to pick and choose the best stocks and funds to invest clients' money in, with the goal of performing better than benchmark indexes, such as the S&P 500, which includes the stocks of 500 large companies.

Conversely, passive funds aim to mimic the indexes, including in their portfolios the indexed companies' stocks. The goal of these funds is to match the market, not beat it.

Finance experts attribute the rising popularity of passive funds to a greater awareness among investors of the fees they are paying for actively managed funds — many of which aren't beating the indexes.


"I think investors are starting to realize they're paying all these fees for actively managed funds and there's no guarantee they're going to outperform," said Mark A. Johnson, an assistant professor of finance at Loyola University Maryland. "They're asking themselves, 'Why am I paying for something I may or may not get?'"

The popularity of passive investing will put pressure on active managers to beat the benchmarks, and on investment firms to be more competitive with their fees, he said.

"They've always had pressure to do well and perform," Johnson said. "This is going to put more pressure on them."

The way active managers have responded to the trend varies widely.

About 20 years ago, Fidelity, one of the largest mutual fund companies in the world, adopted a new strategy to give passive investing a much larger role in its business, said Brian Hogan, president of Fidelity's equity and high-income division. Today, the Boston-based firm has about $230 billion in passive assets, or just under 11 percent of its total assets under management.

Passive funds are on the menu for clients of T. Rowe and Legg Mason but remain a smaller part of business. About 5 percent of the roughly $813 billion in assets under management at T. Rowe is invested in passive funds, for example. Legg Mason does not break out its passive assets from its roughly $716 billion in assets under management because it is a small amount.


Rather than make passive investing a separate silo within their business, T. Rowe and Legg Mason recommend clients adopt diverse portfolios with a mix of active and passive investments.

"For us it's diversification, diversification, diversification," said Legg Mason CEO Joseph Sullivan. "The more we're diversified, the more choice we can provide clients, the more balance we can provide shareholders."

Legg Mason's diversification strategy spans its products, the fund mix in its portfolios, how people can access their portfolios and geographically where its investments and businesses are located.

Passive or active, people are looking for the best value, so T. Rowe wants to show that investors will make more money, on average, by choosing its actively managed funds, said CEO William Stromberg.

"If over time you deliver better value after fees, then over time you should be able to keep your customers happy and ultimately grow business," Stromberg said.

Both Stromberg and Sullivan said they expect passive investing to remain an important part of their business, but think the trend will slow as active managers begin to beat benchmarks again.


Passive funds have been around for decades but became fashionable in 2009, as the stock market began to rebound from the financial crisis, experts said.

Central banks, such as the Federal Reserve, were all lowering interest rates and working together to restore stability to the market, which created an environment in which stocks were moving together, with little difference between winners and losers, Fidelity's Hogan said. That made it much harder for active managers, who tend to fare better in periods of volatility, to beat the market, he said.

The market is cyclical and after seven years of generally rising prices, volatility may be on the horizon — especially following Donald J. Trump's upset win of the presidential election, experts said.

Investors and businesses are unsure how Trump will govern and how his campaign promises about overhauling tax policy, restricting immigration and renegotiating international trade deals will play out.

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Many financial experts expect uncertainty and volatility that may vary by sector, which could favor those with active strategies, said Jonathan Murray, managing director of wealth management for UBS Wealth Management Americas.

"You can just buy the S&P Index in a passive way and you'll have exposure to all of them, but if you have good research that can show you certain sectors are going to outperform others, why not overweight those sectors?" Murray said.


For example, banks expecting a boost from tax and regulatory reform under Trump could fare better than stocks of hospitals and insurers should Trump to make good on his campaign promise to repeal the federal Affordable Care Act.

While many experts and fund managers believe the pendulum may soon begin to swing back to active funds, they agree that the investors and fund managers who are most successful will be those who find a way to marry the two strategies.

"I don't think this has to be a contentious right-wrong, good-evil debate," said Berman, the Timonium wealth manager. "The two can and should co-exist."