Avantis’ McInnis on Active vs. Passive Spectrum

and a very long debate. Today, I wanted to look at that through a more teumatic lens. What's actually changing, where active might have an edge and what tends to get more competed away over time. So here to talk about that is Phil mckinnis, Chief investment strategists at Vantis Investors. Phil, thank you for joining me today. Thanks David, it's a pleasure to be here. I'm excited about this. So we're hearing a lot right now about you know, the shift

back to active. What part of that narrative do you think is overstated or misunderstood. I think there's there's a couple of things that are really important to really contextualize it. Because you have the types of strategies that are out there. You also have the vehicles through which people are accessing them.

And so if we're talking about active relative to passive, I think right alongside it you have to talk about ETFs and mutual funds because for a long time, you know, many of the ETF options, or the predominant ETF options, were passive of some sort, right, there was some sort

of index based mechanism. And so if we think about kind of market share there between mutual funds and ETFs, you know, ETFs had around fourteen percent, sixteen percent market share if we go back to say twenty fourteen, go back to a little bit more than a decade ago. If you think about, you.

just a massive amount of money. So I think the concept of what vehicles are people choosing and then what is the kind of the strategy of those underlying vehicles is something that's pretty important to start with.

it has to be still contextualized. Of it's a big choice of the ETF vehicle over the mutual fun vehicle, and I really don't see that reversing. So I mean market leadership.

among indexes. If it's a non total market index, I contend that there's still some form of security selection that is going on. Right you have to determine how is it how are we constituting it as a value stock? What's our ceiling for a small cap portfolio or a floor for a mid or large cap portfolio. These are active decisions. And so if we look at the growth in indexing and where it's come from, I really don't think a lot of it has come from people stepping

back and just buying the total market. That's happening, but not nearly to the same level as people are buying components of the market that can be sectors, that can be styles, that can be market cap segments, it can be factors as well. Right, different sort of slices of the market that technically track an index. There's a set of rules, there's a methodology that you can go and read, and so the funds are tracking that index. But is that really passive. No, I don't really think that it is.

I think that it might be passive at implementation, but there's still some active security selection that's going on. It's just a matter of who's doing it. So has it been concentrated at the top? Yes? What's really led to that two things. There's been really tremendous earnings growth at the top end of the market, and there's also been some pretty significant multiple expansion, Right, so as fast as the earnings have come out, the prices have extended further

beyond that, they've risen even faster. I think it's still a time where folks should not be overlooking the rest of the market. I would contend there's still plenty of really really good opportunities that are out there where you can get a lot of the same characteristics that you might appreciate in a total market kind of passive strategy. You can get things like broad diversification, low turnover, low fees.

Those options exist, but you can still pay attention to valuations, right, That's really one thing we try to center ourselves on at Avontics is paying attention to valuations, and so I think there's still an element of just not paying attention to price and isolation, not paying attention to fundamentals and isolation thinking about those in concert. There's always a place for that in the portfolio. So the further I.

things that you do. So the fact that we are going down going and sitting across the table from you know, CEOs and CFOs of portfolio companies and listening to them about their outlook for their respective businesses and it's like, oh, well, you must not be a fundamental manager. We care about fundamentals as much as anybody out there. I would contend

as much as or more than anybody out there. What the strength the underlying fundamentals of businesses are relative to their prices, if they're going to have a spot in our portfolio or not. But we're trying to do it in a really objective way. And so when I think about systematization, that's existed for a long time, right, it's existed ever since computers have been around, is to varying

degrees and forms. If we think about kind of the market and options for people to invest, and how that's evolved over time, it used to be everybody was just out picking stocks, right there. There were stock pickers, and maybe some things started to get systematized a little bit

within there. But I would argue the systematization really started with indexing of people started to build indexes of you know, large cap indexes or small cap indexes, but really just just looking at how big is the company in the market. That's the share it makes up of the index, and that's the share it makes up of your portfolio, and that's really it that's now advanced a fair bit more right over a long period of time of different styles

of indexes and different factors and things. So at avontis what we think about in terms of the systematization is there's parts of our process that if you can systematize it, you can do it faster, you can do it less expensively, right, you can do it more more efficiently, and potentially even at higher quality and better quality control checks than those things.

So anything that we're doing in a very repetitive, repeative, repeated frequency, we try to make sure we have good systems in place to help us do that, to help us do it really consistently, really cost efficiently, because going back to the days of just the pure stock picking, you know that that's a pretty labor intensive and costly kind of an exercise to go and do this really

deep due diligence on individual portfolio companies. So if I can systematize aspects of that and deliver a portfolio that's significantly lower fee but still has that end that sort of bend toward valuations and having good risk management and everything else, we think that that can be a really great deal for investors.

actually labeled active today? What's genuinely differentiated versus just you know, repackage factors, you know, exposure, you know, I know there's a lot of smart beta that you know, some consider active, some don't.

all these different things inside of a portfolio. And so where I come back to is that idea of so around active, right if we because I think there's a there's a really big piece as we think about around active is unless you are holding every stock in the market at its market cap weight, there is some level of active in your portfolio, and so you get into a matter of well who is making those decisions? Are

you making them as an allocator? Is there an index house or another asset manager who's making them on your behalf? And as you think about the idea of well what am I trying to achieve with that allocation? What kind of risk am I setting myself up for as I'm taking that? Am I doing it in the most cost

effective way possible? Those start to become really important questions to answer because the concept of like repackaged factor exposure being passive, right, I think the idea is like, well, if it's if it's just factor exposure, that's kind of a passive exposure. I say, that's really still quite active. All of those things are really active decisions. It's a matter of who's making them and then how cost effectively

are they able to do it? So where I come back to you know, I think if you think about from an attribution framework, right, you can always do an attribution on a portfolio and see how much of it was an allocation effect versus a selection effect. But even once you're into that kind of attribution world, well, the attribution lens that I'm looking at it through. If I'm looking at it through a sector or through a specific set of factors or whatever else, I'm going to have

different betas in different kind of alpha terms. Right, So, even all the models have their own biases that can be built into them. What I think about I think about the allocator, who is really on the hook for this decision at the end of the day. They have to think about, well, do I have a goal? Do I have a goal that I'm trying to outperform my benchmark by? And we could have probably an hour long conversation just on benchmarking, David. So I'm not going to

subject everybody to that today. But if I have a policy benchmark that we agree is reasonable, and then it's what's my goal in outperforming that portfolio benchmark and how am I going to get there? I can do it by me the allocator, trying to tactically overweight and underweight regions or sectors or styles or market cap segments that I think are more attractive or less attractive at different points in time. That's one option. I can put factors on top of it, right, I can lean towards value.

I can lean towards quality or profitability if you have folks who do it that way, or I can outsource a lot of the stock selection to folks who are going and trying to find what they believe are the best companies. So build a portfolio of many concentrated active strategies and then look at my factor exposure and maybe

try to offset some of if I don't like it. Right, there's so many different choices, But if you don't have a goal for what you're trying to achieve above and beyond that benchmark, then it's really hard to talk about what risk is and what risk looks like because that concept of it. If I want to outperform by a percent and a half, well, how much active risk do I have to take to make that a reasonable achievable goal? And how much of that am I outsourcing the decision

versus I'm keeping it I have control. The more you have active managers in that camp, the more you're outsourcing it, and they may decide to do something differently right. They may change the stocks versus what they add last quarter, last year, and that might change the way they look in the portfolio relative to what else you have. So

at avontis. One thing that's really important for us is we know anytime we're being hired, there's this trade off between we're being hired to deliver that underlying asset class, but they're choosing us because they think we can do better than just market cap weighting within that universe. So we have to think about managing that trade off effectively, and I would argue that we're as good as anybody out there doing that of making sure that sort of

jobs one and two are designed. The portfolio is what does a good job of delivering that underlying intended asset class, and we do our job. We'd play that role in the allocation, but we have more information about differences than expector returns across stocks, and we can use that to not really meaningfully change the risk profile of the strategy.

We might have some tracking her to a small value benchmark and our small value strategy, but it's not going to meaningfully contribute to an active risk or tracking error to the overall market level versus just using a small value index fund. So we think it can be a really effective tool for folks to use in those allocations, But the differentiation has to come through in that net a fee result at the end of the day.

signals versus one that's that's focused on valuations. So if one is really really focused on signals, of I've identified something that I think the market is is mispricing and there's a there's the signal that gives me that information, and so I'm gonna hammer that and and extract a premium because of it. Right, And they're constantly having to sort of rotate through what those signals are because they're being arbitrage away because other people are identifying those same

signals and kind of crowding into those traits. That requires a lot of signals, and it requires a pretty high rate of frequency in terms of the turnover among those signals. So that process is one that I would say as a really high bar in terms of constantly having to refresh and find those new sort of areas of mispricing. What we do is much more grounded in valuations, and

I would argue that that's a lot more stable and persistent. Right, The chances of a relationship between a lower price company relative to fundamentals and a higher price company relative to fundamentals of that premium over time flipping and going negative for long periods is not something that makes a lot

of sense to me. Right. The magnitude of those premiums may change, but the concept of if I'm paying a lower price to get the same level of equity and profits in a business, and over time, I expect that to compound at a higher rate I get better returns. I don't, you know, I'm very comfortable with the long term nature of that and conviction that. So that's really

the process piece. On the cost piece, there's a large asset consultant that throughout sort of a two thirds one third they believe that a manager should eat no more than a third of their excess return. So I don't think that's an unreasonable kind of a bogie if you think about a two thirds one third split of the client keeps two thirds and the manager keeps a third. At Avontas, So we've had strategies up since since September

twenty nineteen. If I look at the strategies that have been around, you know since that time, the split that we've given to investors is closer to ninety ten, right, as far as ninety percent of the access return going the investors ten percent for Avantas. So I feel like we've done a really good job for investors or investors have gotten some really good value add from our strategies.

cap only portfolios, small cap only portfolios. We've got portfolios that just do it in the US or do it in non yes developed markets or emerging markets. So there's a lot of different sort of fishing ponds right where we're applying this, but we have one way of fishing.

DA said, we're doing this across more than fourteen thousand companies across more fifty some odd countries every single day, right, So that's a lot of data that requires some really really good systems and checks in place to make sure you've got clean data that you're organizing it effectively, and that you're serving it up to really informed portfolio managers investment people who can interpret the outputs of that and

use it to make good decisions. Right, So I would contend that you need to have expertise in all those areas. I would contend that you need to be paying attention to all those areas because you don't know where the next edge is actually going to come from. It can come from many different aspects within that, but it takes all of it together working in concert to create a good portfolio. Right. If we said, well we've got really strong portfolio managers, but our systems are crap, that's not

going to lead to a good outcome. Right, You need all of it together. Sometimes people ask us that of what's more important is that the systems of the portfolio managers, And tongue in cheek, I say, well, what do you like most about pizza? Right? Do you like the sauce? Do you like the cheat? It tastes good because it all works together. And our portfolios we think they work well because everything works well together.

this reasonable? Does this make sense? Right? We talked about wanting to systematize anything that we're doing with a very high rate of frequency so that you can do it more efficiently and do it more cost effectively. But there will be exceptions. There will be new things that pop up, and you need portfolio managers to be able to interpret those and make decisions and surface them to the team. So I feel like that's one piece for sure. You can't just set it and forget it. Not not even close.

But the other thing that I think is it relates to systematic strategies and maybe even more broadly, the communication around them, I think is really really important setting and managing expectations effectively for investors, because it doesn't matter what kind of strategy you manage. If you're active, there's going

to be a time when you underperform. And if you have taken a lot of shortcuts in how you explain the strategy, and you've just said, look, look at our sharp ratios, look at our information ratios, and just kind of smile and say, like, we've got good number. If folks are surprised by the results that have come out,

then they might not stick around in the strategy. And in my mind, that's the worst outcome for everybody, because you know, they're hiring you when you got good returns, they're firing you you got bad returns, and what did they get out of it?

of that. You look at small cap stocks in the US, is profitability quality, something was rewarded noll R right, not at all. Our small value strategy did not farewell in that environment. But as I was doing client reviews, we're sitting down with the of walking them through. Here's what you hired us to do. These are the types of companies we focus on. This is what happened in the

market or over this time period. They're okay, right. It doesn't mean we like underperforming ever, but it's reasonable and it makes sense given the broader market environment. Are not going to change our stripes because of a six month or twelve month period. So I think that communication is really really important.

with that, right. And the beauty of our process is if I'm holding a bunch of companies that have those attractive prices to underlying fundamentals, if a whole bunch of other investors show up and bid up those companies, the prices of those companies and the fundamentals don't change. Guess what happens. We sell them. We sell those companies, and we're going on reinvesting the proceeds into more attractive opportunities.

So this this daily process, right, the keeping our eye on the ball there is something definitely makes a lot of sense. But also we are not chasing these really really kind of fast moving signals, you know, trying to find a lot of elements of mispricing is trying to identify that value that is reflected in those prices and fundamentals.

So I think there's some more staying power there. And you know, you know, every market where there's success, there's the potential risk of things being crowded by like a me too product or those kind kinds of things. We try to make sure we're restaurant orwers of look this

is what we focus on. This is what we're signing you up for, and then just doing our job, you know, just making sure that you can count on us to do what we said we would do, because I think in the investment world that goes a long long way if folks know they are going to be surprised by your results.

report that I was looking at. So that's a number, that's a number of options to contextualize the thousand, I think somewhere in the neighborhood of like one hundred passive ETFs and or index based ttfs and one hundred and fifty mutual funds that were launched over that same timeframe. So clearly there's a lot that's going on in the active space.

you know, active ETF options than they've had today. And choice is not necessarily a bad thing. But is it choices that can really drive meaningfully good kind of outcomes for those long term oriented investors. I'm probably a little bit more skeptical of that. I think you have to would have to dig deeper into the underlying piesis of each of those portfolios, you know, with the with the commoditization. You know, you see it in fees, right, fees have

come down significantly. If you look at where the money is going among active etf it's not really going to high cost active ETFs, it's going to lower cost activettfs. So that shift from mutual funds to ETFs that I would contend is absolutely about tax efficiency and things like the rapper provides, but was also just an emphasis on costs, lower costs ways of achieving the same exposure in a portfolio.

So costs are still going to matter. I think they still should absolutely matter for investors who are evaluating these things. But I think you gotta with whether it's active, whether it's index based. I don't know if allocators of like hearing this answer or not, probably depends on your role. I think you gotta you know, you got to open the hood, you got to kick the tires. You got to understand how does the stock get into the portfolio, how is it weighted, and then when might it leave

right and why would it leave. You have to understand that to understand the role it's going to play in your portfolio. The other thing I would say is you look at kind of ETF sponsors as a somebody's doing due diligence. I think it's a great question to ask people if how do you think about product development rights? What's causing you to bring new strategies to market? Or why did you launch these strategies?

it's really important. So the way that I think about it, if you're evaluating a manager, I think that there's there's three questions that you really need to be asking and before you start looking at any sort of you know, MPT stats or a lot of data or anything else. So one is you know, so explain to me how you take active risk? Right? How do you put names into a portfolio? Why do they make it in there?

So you get an understanding of that process us, Right, how are you and then how does that translate to adding value above and beyond the benchmark? So that's sort of component one, Component two. Okay, what are you expecting to generate above and beyond that? Right? So that gives them a sense of if they got an access return target, and what's the what's the tracking error that's going to

come with that? Right, what's the active risk that they're taking. See, you have some semblance of that, and they should be able to show you, you know, why is that a reasonable number or not? Right? So does it make sense relative to to to what they're doing, what kind of kind of peers are they going to underperform it? And then finally, what's the fee you're going to charge me? Right for that endeavor? So if you have those three things lined up, and do you think that that cost

is reasonable? If you have your head around that as an allocator, then starting to use attributions or MPT stats or whatever else can start to help you check and analyze and and really see if it matches up relative to what the manager is telling you they do, and you can get a lot more comfort. Right, But you have something like downside capture gets thrown around a lot, right, It's a, Oh, we got really good downside capture. I

want to manage it. As a good downside capture I can show you, Or I can look at a downside capture number of a portfolio and it might tell me a lot about the way that the manager is managing the strategy, or it might tell me absolutely nothing at all, right, depending on how exactly they manage the strategy. Because think about twenty twenty two. If you had a portfolio that favored value at all in the US, it was going to look like you had great downside protection why or

downside capture? Why growth stocks? Growth stocks were really what came down right, They were falling down in price in twenty twenty two. So if somebody looks at that and said, I want this manager because they have good downside protection, well, if I'm not managing it for downside risk, if it just was episodic based on that market environment, that number is pretty meaningless in that context, right, I shouldn't expect

it the next time. So I think it's really you have to answer those core questions so that you can start to form your own expectations of what should I expect this strategy to do well or not do? So well, and am I comfortable with that? You know, sort of

range of outcomes. Those are the really important things to get across versus sort of coming with the objective first of I want this, and then I'm going to screen on those measures and I'm going to get to a universe of strategies that provide that, and then I'll figure out which one is the best one. I'd always start back at the the thesis first, right, how do how do these managers work? First? And then see if it

matches up with what you're what you're looking for. Okay, so my last question for you is, you know, I know we covered us a little bit. We talked about how you know, a lot of launches recently. You know, a lot of that is you know, leverage, single stock. You know, you get to find out CUB as well.

Because I still put all those within the realm of active in some fashion. Uh. And so there, if you're you know, whether at ANYTF that is labeled active or ANYTF that is labeled index, I think we got to dig a little bit deeper to be able to say which is the better way of doing it. With with Avantis,

we you know, we would argue. So if you look at costs, if you look at the level of diversification that's available in a portfolio, if you look at the turnover levels of a portfolio, we had a lot of portfolios that are pretty darn low feet low turnover, pretty broadly diversified, really tax efficient with the ETF rapper that again i'd put a stamp on that and say validated, Like if I can check off those things, I think a lot of allocareas are very happy to have those

as tools in a portfolio, regardless of what the label is. So you know, we've we started in twenty nineteen, we had five ETFs at that point. We've launched a lot more. But I said earlier about you know, talking to a manager how they think about product development. We don't on strategies and helps that people show up. We go and talk to people as to what else they might need and how we can help. And that's what's going to lead us as far as what you know, what's sort

of next out there. So that I think is a much more sustainable way of growing a franchise of strategies that are available, solutions are available to investors, and it's as well sort of our clients. Well, we're around one hundred and thirty billion in total assets under management now, you know six and a half years later. That doesn't

come from you know, I would say being lucky. It comes from hopefully, you know, doing what you say you would and having things that really embody all the characteristics of things that people want in a strategy. So I'm maybe cheating a little bit here in terms of that validation, but I like to borrow from both disciplines. I think there's disciplines of active management that make a lot of sense in a portfolio. Daily oversight, have a sun, valuations

and things. There's also elements that may be more often associated with passive back to the broad versification, low fees and things that I also think are good components of a strategy. So we're going to have those embedded. If we can blend those effectively together, we think it can

translate to really good outcomes for clients. And you know, those those five strategies that I was talking about, if you look at their average net access return versus their benchmark, you know, with over three hundred basis points annualized of fees. So we again feel like that's a pretty good deal that investors have gotten and we're happy to keep doing it for them. Great.