The Active vs. Passive Framework, Updated

The duo of Passive/Active becomes the trio of Passive/Strategic Beta/Active.

John Rekenthaler 20 July, 2016 | 15:03
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Everybody knows that there are active funds, and there are passive funds. Those are the terms used across the industry--by investment consultants, financial advisors, the media, fund companies, you name it. Including Morningstar. That language, however, has become outmoded. It was fine until about a decade ago, when active funds were active funds and index funds were not. But in recent years, it has strained to keep up with changes in the fund industry. The result: Semantic confusion, as people use the same words to state different things.

"Active," for example, currently has two meanings. One is that a fund is managed, so that it does more than mimic an index. (This definition is not as straightforward as it sounds, because index funds sometimes deviate from their benchmarks, so as to reduce trading costs. But in practice, one can usually draw the line.) The other definition of active is that a fund incorporates a market viewpoint.

The question then becomes how to describe an exchange-traded fund that emulates an esoteric index. Consider an investment manager who creates a 15-factor stock-selection model, builds an index that consists of the model's 50 highest-scoring stocks (recalculated quarterly), and launches a fund based on that index. That fund would be passive according to one definition of active, and highly active according to the other definition.

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John Rekenthaler  is vice president of research for Morningstar.

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