‘THE BEST OF BOTH WORLDS’

IN DEBATE BETWEEN ACTIVE AND PASSIVE FUNDS, A THIRD OPTION IS GAINING TRACTION

Investors have long debated whether to opt for cheaper exchange-traded funds, which track a broader index, or to stick with active funds, which have higher fees but are overseen by a manager who can make changes depending on market conditions.

If fund flows are any indication, the passive side appears to be winning the debate. Money flowing into ETFs has been accelerating in recent years, hitting the magic milestone of $100 billion in Canada earlier this year. ETF assets have now doubled since 2010, as the $1.1 trillion mutual fund industry struggles with outflows.

But as the money has shifted from active to passive, some managers have begun to warn that investors are losing the important benefits of active management, and a third option has emerged: hybrid funds.

“It should definitely be a blending of both strategies,” said Sadiq Adatia, chief investment officer of Sun Life Global Investments, which has expanded its offering of hybrid products. “I think in the past investors were too far into the active approach, but now we may have gone the other way and are too far into the passive approach, because everyone is focusing on fees.”

Around the world, fund providers have been in a race to lower fees for both passive and managed funds as investors have increasingly woken up to the fact that such charges were eating up a large chunk of their returns.

Exchange-traded funds, which often simply track an index, have led the way in lower fees. Last November, asset manager BlackRock Inc. said it would cut the cost of its ETF fees by more than 50 per cent. It followed up those cuts with cuts on more than a dozen funds this month, including the popular iShares Core S&P 500 ETF, which saw its fee slip from 0.07 per cent to 0.04 per cent.

Data from Morningstar Inc. shows that in the U.S., more than 100 mutual funds and ETFs now cost US$10 or less for every US$10,000 invested — which translate to a fee of just 0.1 per cent. It is almost unthinkable that just two decades ago, most mutual funds were charging a minimum of two per cent a year.

But Adatia warns that the race for lower fees mean that some of the benefits of active strategies — adjusting portfolios to market conditions, finding value, avoiding indices when a particular group of companies become overvalued — are being lost.

He blames that on fund managers in the past who would allows them to adapt to market conditions in ways that regular ETFs can’t.

Managed ETFs offer investors exposure to a variety of ETFs, with an experienced manager overseeing the investment. The market has been expanding in Canada, with Vanguard Investments Canada Inc. in June introducing four actively-managed ETFs in the country for the first time, all with fees of 0.35 per cent.

Sun Life’s Granite portfolios fit the growing list of hybrid products. The funds are overseen by Adatia and his management team, and are occasionally adjusted when needed, including during periods of market volatility. Each portfolio is made up of 11-15 funds, offering Sun Life funds, as well as access to third-party funds and other managers.

Some of the funds are active, with managers overseeing a collection of assets. Others employ passive strategies and the low fees that come with them. Adatia says the funds allow investors to get exposure to a variety of investment styles and successful managers, increasing the diversity of a portfolio.

A number of investment firms are now recommending their clients build portfolios with passive and active components, saying the days of a single-strategy approach are long gone.

“The debate over whether one should choose an active or passive approach is ultimately misguided because investors can benefit greatly by combining both approaches in the same portfolio,” said Leon Zerilli, head of John Hancock Investments in a recent report.

Adatia said that he expects that in the future, most investors will be into hybrid strategies and build portfolios that don’t simply lean on a single tactic.

“It’s the best of both worlds,” he said.