Part 1 of 2 on Investing:
Active vs. passive investing
For this article the passive approach will be reflected by the S&P 500 stock index.
It’s easy to get caught up in the Wall Street hype about which investment approach is better.
My friends at Frank Russell Investments provided a good description of the difference below. I personally work with either client preference, but tend to like the manager’s ability to use their discretion in declining markets when protecting client assets from major declines.
In the end, every strategy must tackle the question: What assets should I buy today? And there is not a totally passive way to answer that.
Some people spend too much time splitting hairs on Active vs. Passive analysis when investor returns are influenced far more by portfolio allocation and buying and selling decisions.
Active vs. passive: The basics:
Active management is simply an attempt to “beat the market” as measured by a particular benchmark or index. For example, an investor might buy or sell certain stocks to try to get better returns than one of the stock market indexes such as the S&P 500 Index or the Russell 1000® Index.
The aim of active fund management — after fees are paid — is to outperform the index for a particular fund (not to mention other fund managers they may be competing against). Prevailing market trends, the economy, political and other current events, and company-specific factors (such as earnings growth) all affect an active manager’s decisions.
Passive management is more commonly called indexing. Indexing is an investment management approach based on purchasing exactly the same stocks and bonds, in the same proportions, as an index. This management style is considered passive because portfolio managers don’t make decisions about which components to buy and sell; they simply copy the index.
Which approach works best?
Proponents of each believe their approach is the right one, the one that has the potential to generate the greatest amount of return over the long-term. Hard facts aside, active and passive management are in many ways similar to political parties. The two camps see the investment world in very different ways, both making logical and passionate arguments for their viewpoint.
Passive managers generally believe that it is difficult to beat the market. Therefore, they essentially offer performance that closely matches an index for those investors who are unwilling to assume the risks of active management.
Active managers believe the market can be beaten. While they can’t beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.
Active management advantages
• Expert analysis — Seasoned money managers make informed decisions based on experience, judgment, and prevailing market trends.
• Possibility of higher-than-index returns — Managers aim to beat the performance of the index.
• Defensive measures — Managers can make changes if they believe the market may take a downturn.
Active management disadvantages
• Higher fees and operating expenses.
• Mistakes may happen — There is always the risk that managers may make unwise choices on behalf of investors, which could reduce returns.
• Style issues may interfere with performance — At any given time, a manager’s style may be in or out of favor with the market, which could reduce returns.
Passive management advantages
• Low operating expenses.
• No action required — There is no decision-making required by the manager or the investor.
Passive management disadvantages
• Performance dictated by index — Investors must be satisfied with market returns because that is the best any index fund can do.
• Lack of control — Managers cannot take action. Index fund managers are usually prohibited from using defensive measures, such as moving out of stocks, if the manager thinks stock prices are going to decline.
Taking a long-term view: Wall Street will continue to debate the benefits of active versus passive investment management. And from time to time, one approach will be more popular than the other. Hindsight is 20/20 and depending on the time frame either side can make an attractive argument.
As an individual investor, try to ignore the trend of the moment. When all is said and done, keep in mind that both active and passive managers are selecting investments from the same pool of equities.
Morningstar had an interesting, unbiased article on this subject and while there were strengths and weaknesses pointed out for both strategies, this is the one point that strikes home with me because it is about PROTECTING YOUR PORTFOLIO.
The article lists eight questions to help as a guide to making a choice. In my practice, question 3 sticks out and is a major factor for investing client’s retirement money.
Question 3: Is risk control a key consideration?
Yes: Favor active funds that emphasize downside protection.
No: Favor index funds.
Over time (I was in this business when the DOW was at 1,722), I’ve come to conclude that one of the key virtues of active strategies is the ability to control risk. It’s something that many of the best, most thoughtful managers are able to excel at. Because active managers can build cash or avoid overheated market segments, they have the potential to keep volatility down relative to index products that have no such latitude. Not only do relatively strong returns in down markets mean that defensive active managers have less ground to make up in rallies, but Morningstar data have tended to show that lower-volatility strategies do a better job of keeping investors in their seats.
Most of my clients are hoping to grow their money, but are equally concerned with protecting what they have from another major decline. As we get older, there is obviously less time to recover. The fear becomes more real and true.
They want a truly well-diversified portfolio, appropriate managers or indexes, a systematically rebalanced portfolio and monitoring the risk-adjusted performance of each and every investment. This takes time, talent, and a special temperament.
In the end, our view is that passive investing is a welcome development, but an unfortunate term. It is a welcome development, in that it has provided a popular alternative to investing in ineffective mutual-funds. It is an unfortunate term, because there is no such thing as a truly passive investing strategy.
Every strategy must tackle the question: What assets should I buy today? And there is not a totally passive way to answer that.
With all that said the “hindsight winner”
is dependent on the time frame: