Active vs. Passive Investing: Why are you forcing yourself to choose one?

If you have invested at all, you are likely to have heard about the debate between active and passive investing. Sometimes the discussion is strong enough that an investor may feel forced to choose a side. But you don’t have to choose; you can have the best of both worlds. Let me tell you how.

Passive Approach

Passive investing is based on the belief that an investor or money manager cannot beat the average returns of the broad market over the long-term. Therefore, investing is focused on broad baskets of securities that represent the market.

Indexed mutual funds and ETFs track what is called an index. An index is not investable but offers a way to track a variety of securities that represent the marketplace. For example, most of us know about the S&P 500 Index. The S&P 500 Index tracks 500 large company stocks that trade on the NASDAQ and New York Stock Exchange. You cannot buy the S&P 500 Index, but you can buy a fund that owns the same stocks as the S&P 500 at the same weightings. Because no one is analyzing the companies behind the stocks, a fund that mirrors the holdings of an index can be owned for a small fee. Operational procedures are more efficient with a passive index fund, also helping to reduce the expenses. Expect fees for passive strategies to range from 0.05% to 0.50%, as a norm.

Active Approach

Active investing refers to the belief that if an investor or money manager follows a strategy of selecting securities with a distinct advantage, which may lead to excess returns over the broad market. Strategies for active investing are unique from one another, and they typically will have success during distinct market periods. A money manager or team of analysts will study securities and use their process to select which belong in their portfolio. The sell criteria for securities is as crucial as the selection criteria with active management. Funds that offer an active strategy are likely to cost more than a passive one; fees can range 0.50% to 2.0% of the assets invested.

Studying investment strategies for the last 20 years, I have seen areas of the market where the securities act much more similar when it comes to price movements and market volatility. One place we see this is with large company stocks. We have also seen an increase in the similarity of movements between large company U.S. stocks and large company foreign stocks. Because this group of stocks has very similar return results, it becomes much more difficult for an active manager to outperform the broad market. Large company stocks tend to have a more substantial portion of an investor’s portfolio and holding a low-cost investment in this asset class can be a benefit.

Broad exposure to the bond market is another place where a passive strategy works well; using an index fund or ETF. Because we don’t see large returns from this asset class as a norm, a low-cost strategy is key.

To get the benefits of active management, find a niche or unique sector of the market. Things like international small-cap stocks or U.S. microcap stocks are places where companies are still unique and may act differently. The company structure, management team, and competitive advantages have a more significant impact on the profitability of these types of companies. Similar company characteristics will impact corporate bond performance. Corporate bonds, high yield bonds, and foreign bonds are asset classes where active management may work well.

 

The Core and the Satellites of Your Portfolio

Consider a passive or indexed approach to investing for the base or core of your portfolio; maybe 60% to 80% of your account value. Use the remaining amount of money, 20% to 40% of the account value, for active investing. Many portfolio managers call this a core-satellite approach, where your core strategy uses passive index investments, and then you enhance the remainder of the portfolio with active satellite strategies. Don’t overwhelm yourself, just take one asset class at a time and start researching where there are unique areas and where a strong analyst or money manager can make a difference in your returns. If you are going to use active management, it is critical to understand the strategy the money manager will use, and during what types of market environments they are expected to perform better in than others.

Take Note

Remember to review the costs of your overall portfolio. It is good to have a target cost that you want to stay below so that your return is as much as possible. See if you can get the total costs related to funds and ETFs to be less than 0.50% of your portfolio value. Remember brokerage fees and advisor fees are taken out of your account as well as fund fees.

Also, don’t assume an ETF is always completely passive as we described above.  New indexes are created every day that an ETF can mirror. Those new indexes are created as a way to improve return possibilities over the broad market. The industry calls this enhanced indexing or smart beta. For example, a new index may get created to include specific growth criteria, or requirement for purchase, for stocks in an index like the S&P 500. The added criterion takes the number of holdings from 500 to 125 stocks. The portfolio of the fund becomes much more concentrated with fewer stocks, but the enhanced growth criterion is believed to be a benefit.  This type of indexed portfolio could be seen as a satellite to the passive core we talked about above. It is no longer a representation of the broad market but now has a focus.  Be sure you understand the difference between a broad market fund and an enhanced index or smart beta fund when looking at new ETFs that are coming out today.

Take your time and really look for good positions to fill your asset allocation strategy. Not all index funds or ETFs are created equal. Look at their history and fees and make good choices based on the criteria you want.  If you need help see our mutual fund selection post here.   Get started; the time is now, and knowledge is KEY!

 


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