FundQuest to blend active and passive strategies

FundQuest plans to launch several mutual funds based on in-house research to create active and passive strategies within a single portfolio — a first for the mutual fund industry.

“Their approach to [investing] sounds unique,” said Sonya Morris, fund analyst at Chicago-based Morningstar Inc. “As far as using their study to determine how much active and passive [strategies a portfolio should pursue], I don’t know of anything like that in a mutual fund.”

In its foray into the mutual fund business, FundQuest of Boston plans to offer four U.S. equity funds, three U.S. bond funds and three international funds. The 10 funds will have different ratios of active and passive management, based on the firm’s research. The Securities and Exchange Commission is expected to approve the funds by the end of December.

The in-house research that Fund-Quest completed in October (InvestmentNews, Oct. 8) showed that asset class is the key to determining an investment strategy. The study evaluated more than 16,000 actively managed funds and examined historical data going back 15 years to determine the asset managers that outperformed their benchmarks and how they achieved that goal. Then the company made recommendations for active or passive management for each asset class.

“Each fund [of ours] will leverage that research,” said Timothy Clift, chief investment officer at Fund-Quest. “It will be a true hybrid of active and passive [management] in a portfolio. We are trying to capitalize on the combination.”

An analysis of research from FundQuest will determine the percentage of actively and passively managed investments within each portfolio. FundQuest will hire subadvisers for the active management portion. The passive investments will involve exchange traded funds or passively managed mutual funds that follow an index.

“In every asset class, you can find active managers that can beat the index,” Mr. Clift said. “We will apply active management where we think we have more of a chance to do that.”

The ratios between active and passive investments will change over time as markets fluctuate and performance changes, Mr. Clift said. “We might allocate more to passive if the asset class index is harder to beat.”

For investments where there is readily available information and insightful research, it is less likely that a portfolio manager would uncover anything that 50 analysts haven’t already discovered.

In investment areas that are less efficient — which relatively few analysts cover — there is much more of an opportunity for active management to improve returns, said Mr. Clift. For instance, emerging-markets stocks are inefficient, so they would have a high allocation in the active category, perhaps 90%. “These stocks experience much more in spikes and volatility,” Mr. Clift said.

In contrast, because they are so widely followed, large-cap investments will have a lower allocation of active management, perhaps 35% to 40%, he said.

The aim is to uncover the best-performing ETFs and combine them with the managers who have generated the best returns. To select the managers, FundQuest calculated the average performance of active managers in each category.

Despite the due diligence, it is not clear that performance can be predicted.

“Even in an asset class where you have a decent chance of outperforming the index, you’re still going to have the problem of being able to identify these managers ahead of time,” said Chuck Neff, a wealth manager at Balasa Dinverno & Foltz LLC of Itasca, Ill.

There is value if the investor believes in the research, said Jeff Bernier, managing director at TandemGrowth Financial Advisors LLC of Roswell, Ga.

“It seems interesting if you buy the argument and have the confidence in their ability to pick the managers for you on the active side,” he said.

Mr. Bernier remains cautious about the costs of the funds.

“The layers of cost are a concern,” he said. “One of the benefits of passive management is lower cost. If you take a lower-cost vehicle and wrap it into another vehicle, you are layering in administrative costs and expense ratios. It sounds like a good idea, but you’d have to measure if you could do it cheaper by buying multiple products.”

However, FundQuest expenses will be competitive, said Mr. Clift.

“The costs are certainly higher than index funds, because you are adding the active-manager cost to that, and you’ll have a blend of the two,” he said. “You’ll also have a FundQuest advisory cost. But the expense ratio will certainly be competitive with other subadvised funds.”

The expected expense ratios of the funds range from 1.45% to 1.79%, and they vary based on the amount of assets in the funds, the cost of subadvisers, the asset class, the ratio of active versus passive management, and other factors, said Mr. Clift.

If fees are too high, FundQuest might have a difficult time generating good returns, Ms. Morris said.

Sue Asci can be reached at [email protected].