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In today's increasingly complex financial world, it's imperative that we use whatever tools are available to us in order to meet the needs, goals and objectives of our high net worth clients. The relative merits of active and passive management have been a hot topic among investors for the past few years, with passionate arguments on both sides of the debate. We think it wise to take a step back and recognize that active and passive solutions each have their own strengths and weaknesses; each solution can be useful when employed in the right circumstances.

With that in mind, we believe that actively managed solutions are better suited to the current market environment than passive ones, and are confident that the best investment strategies and solutions reflect our active, disciplined and dynamic approach to allocating resources within a portfolio.

Defining Active and Passive Management

An active manager continually seeks alpha (that is, return above a stated "market return") by finding quality companies that will grow faster than the market or peer group through a combination of research, fundamental analysis (using metrics like price-to-earnings and price-to-book) and professional experience. The active manager's goal is to try to exceed the return of a particular benchmark over a period of time.

Conversely, a passively managed, or index-based, solution simply replicates the holdings and thus the return (or beta) of a particular benchmark, providing exposure to a broad array of securities through an index mutual fund, exchange-traded fund (ETF) or a separately managed account.

In recent years, passive investment solutions have grown in popularity. Between 2007 and 2018, more than $3 trillion in new cash and reinvested dividends has been invested in ETFs.

There are many reasons why the adoption of passive solutions has increased over this time period, including lower fees, greater availability within retirement plans, market trends (such as abnormally low interest rates — that is, below the rate of growth as measured by GDP), high correlation among stocks and the outperformance of U.S. large cap over small cap equity. In this environment, stock prices may have more to do with supply and demand or the "market value" of the benchmark investments and less to do with "business value," which does not favor active management based on fundamental analysis.

The introduction of higher capital gains and income tax rates and the net investment income tax that was implemented in 2013 played a role as well, as active managers tend to generate higher realized gains through higher turnover.

New Opportunities for Active Managers

We believe the less volatile environment that supported the move toward passive strategies has changed. Over the last year, we have seen increased volatility in the markets, creating more opportunities for active managers.

The Trump administration has delivered on promises to cut tax rates across the board, increase fiscal spending and reduce government regulations. We are experiencing more normalized interest rates, increased earnings due to lower tax rates, less regulation and higher inflation — giving firms better pricing power. These changes will generate winners and losers among publicly traded companies, and being able to differentiate between the two will be far more important going forward. They are the catalyst for a much more favorable environment for actively managed solutions than we've seen in recent years.

Increased Volatility

If we take a closer look at shorter, more volatile periods in the market, such as the downturns of 2000-2002 and 2008, active managers were better able to generate returns that outperformed their benchmarks. In times of turmoil or uncertainty, an active manager's ability to shift investments away from troubled sectors and companies and into safer territory can help mitigate the effects that a market downturn can have on a portfolio. In such environments, being tied to an index by a passive solution could be a liability, potentially causing investors to panic and sell assets at depressed prices.

We expect to see continued bouts of volatility in the current market. In 2018, as of August 30, there were 36 days in which the market closed with a gain or loss of greater than 1%. In 2017, there were only eight such days.

Lower Correlations

Exhibit 3 illustrates the correlations among companies that are included in the S&P 500. The recent downward trend in correlations has created an opportunity for managers who employ deeper analysis and stock selection to outperform the market.

Rising Interest Rates

Further, as illustrated in Exhibit 4, the market environment that caused this underperformance among active managers included an extremely accommodative Federal Reserve that provided three quantitative easing cycles, the last ending in 2014. This created an economy with lower interest rates and drove investors toward riskier assets in an effort to compensate for lower income. Higher rates should help to better differentiate between companies that have strong fundamentals and companies that just provide a higher dividend yield.

Outperformance Among Small Cap Stocks

It's also important to note the recent outperformance of small cap stocks as compared to large cap stocks. Exhibit 5 shows that when small cap stocks outperform large cap stocks, actively managed solutions tend to outperform passive solutions. This is due to the fact that smaller companies are not typically held in index ETFs.

Should this relationship hold as we move forward, we expect that small cap equities and actively managed solutions will continue to do better relative to large cap and passive solutions as large companies begin to feel the squeeze from a strengthening dollar and small companies benefit from the latest tax cuts.

Excessive Concentration Within Passive Solutions

The indexes used as benchmarks for many passive solutions — such as the S&P 500 or the Nasdaq Composite — are market-cap-weighted, meaning that they tend to be overweighted toward the largest companies in the index. This can present a risk to investors in a more volatile market environment. As the value of the index is more concentrated in a few large companies, passive solutions tied to that index become more vulnerable to significant price swings amid increased volatility. Ultimately, this excessive concentration undermines the typical motivation for selecting passive solutions — reducing the risk of underperforming stated benchmark. Additionally, market-cap-weighted indexes tend to be biased toward large cap stocks, which may account for the correlation between large cap performance and passive solution performance demonstrated in Exhibit 5. Active managers have the flexibility or discretion to adjust portfolio holdings in response to market events. This flexibility means that actively managed solutions may be able to reduce risk more effectively than passive solutions in the current market environment. Conversely, passive investors aren't paid a premium for taking on the additional risk in a market cap weighted ETF or index fund.

The Potential Risks of a Growing Passive Market

While the story of active versus passive is still being written, the ever increasing share of the investment pie being dedicated to passive strategies is a transformation that we have not experienced in the past.

This shift has forced active managers to be more competitive. With more assets flowing toward those managers who beat the benchmark and lower overall costs, the ranks of active management have likely thinned. This leaves the rest of the field to find better opportunities, better returns and perhaps eventually attract funds from passive strategies, at least anecdotally.

However, the pace of passive adoption could once again lead to the higher correlations we saw in the period following the 2008 to 2009 bear market, and thus higher risk. It could also lead to a reduction in "price discovery" as fundamental analysis gets displaced by "buy or sell at any price" or indiscriminate trading. A severe market correction may be the catalyst for a better understanding of the impact this new environment has on the efficiency of markets.

An Active Approach to a Blended Solution

Investors need to understand how actively managed and passively managed solutions can be employed in different circumstances. Passively managed solutions tend to outperform active solutions in market environments when everything is highly correlated, or moving in the same direction, and active solutions have the potential to outperform passive solutions in periods when fundamentals play a more important role in stock selection. Given these behaviors, it stands to reason that they can be combined to take advantage of all market environments.

There's no need to choose one solution over the other. Instead, a blend of active and passive solutions is likely to offer investors the best of both worlds: enhanced performance over time and lower volatility.

Investors should avoid getting drawn into a philosophical debate about the superiority of one investment solution over another and instead focus on how each solution may be best employed to the benefit of their long-term goals. How assets are allocated — not just among asset classes, but also among active or passive investment styles — should be driven by a well-thought-out assessment of prevailing market conditions and a forward-looking perspective. Determining the best combination of investment solutions requires a disciplined process that takes a long-term view. Investors should not be reactive in their thinking, but rather flexible enough to think opportunistically in order to take advantage of the cyclical nature of the markets.

At BNY Mellon Wealth Management, we believe that high net worth clients are best served through active management that takes the entirety of their wealth into consideration — their investments, their estate plans and their tax circumstances. Our wealth managers can determine how much should be allocated to active or passive solutions based on the goals and objectives of individual clients. They give careful consideration to the impact of potential capital gains when moving assets between actively managed and passively managed index-based vehicles. In all cases, decisions are driven by an understanding of our clients' long-term objectives and a deep understanding of what it is they want to accomplish.

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