The Great Investment Debate: Active versus Passive

Recently, one of my clients asked my opinion about “actively” managed investments, as compared to “passive” strategies which attempt to track the performance of a particular index. This is not usually the stuff of interesting dinner table conversations, but I do think it is a great question and one that inspired me to share my thoughts on what is an important decision for any investor!

This query also reminded me a little bit about last year’s political elections – not just because politics can be another subject that can spoil a nice dinner time meal, but also because the active versus passive question has sometimes incited heated discussions among investors! Just like political subjects, each “camp” in this debate has strong advocates who argue – sometimes with great emotion and passion — that the advantages of its approach outweigh those for the opposite side.

Passive Management Compared to Active Management
Passive investments attempt to match the performance of an investment with a relevant index. In the process of trying to match the index returns, one of the goals is to minimize expenses that can reduce an investor’s net return (the return after expenses).

This approach contrasts with “active” management in which a portfolio manager tries to beat the performance of a given benchmark index by using his or her judgment in selecting individual securities and deciding when to buy and sell them. The expenses associated with actively managed strategies are almost always higher than the expenses of passive approaches.

file8751304819968Consequently, the active manager needs to add sufficient value to overcome the hurdle of the higher expenses in order to deliver returns that are superior to the index. This goal is not easy for active managers to achieve, especially since most objective research has shown that lower expenses (with both passive and active management) significantly improve the odds of long term investment success. (See Note 1)

And historically, studies have demonstrated that the performance of the majority of active managers have indeed lagged passive or indexed strategies. (See Note 2) Some, though not all, advocates of passive investing have presented this information in a way that suggests using active managers is a fruitless and pointless exercise.

However, according to a March 2013 Morningstar Research article titled “A Bad Year for Active or Passive?”, the results may not be as one-sided as some advocates of passive investing have argued. Still, this Morningstar article acknowledges, no matter how one slices the data, the performance of passive strategies do hold the upper hand in the majority of instances. But, they concluded that does not mean there is not a role for including active management in a portfolio.

Opportunities to Combine Active with Passive
I agree with this perspective — the debate of active versus passive does not have to be all or nothing. In fact, active and passive strategies can live together in the same portfolio and achieve investment “détente”!

Although it is true that indexed strategies have outperformed the majority of active over the long term, there are also periods when actively managed portfolios – especially those with reasonable costs — can do better than the index. As it is virtually impossible to know when either approach will do better than the other, investors can attempt to harvest the benefits of each by using them simultaneously.

In this respect, the two methods have the potential of complimenting one another to help an investor try to attain their investment objective. So how do you go about combining the two? One strategy is to decide what percentage of your portfolio you want to allocate to passive versus active strategies.

This would allow an investor to allocate some portion of their investment allocation to trying to outperform the benchmark they are using to monitor their portfolio performance. In this way, an investor would have the potential of participating in the benefits of passive investing (the opportunity to match the return of the index), while taking advantage of the possibility that a skilled portfolio manager(s) could add value over the long term.

A second (and I think a more compelling strategy) is for investors to try to take matters into their own hands. An investor can underweight or overweight certain market segments using passive strategies in an effort to attain better overall portfolio results relative to their investment objective and/or benchmark.

In other words, this is a way to use a passive strategy in an “active” manner to try to meet investment objectives such as generating income or attaining capital appreciation. And investors can the adjust the weighting of their allocation to market sectors, based on their views of where there might be investment opportunities (or in deciding what type of investment risks they want to try to minimize).

These are just some of the possibilities of how investors don’t necessarily need to exclusively follow the dogma of one particular approach. And although this might not alleviate all of the investment debates (sometimes a good disagreement is just too much fun!), I think using the strengths of each strategy offers the potential of helping investors effectively move toward their investment goals!

Note 1 Following is an example of such research: Sharpe, William F., “The Arithmetic of Investment Expenses” (March 29, 2013). Financial Analysts Journal, Volume 69, No. 2, 2013.

Note 2 Here is an example of one such study – Fama, Eugene F. and French, Kenneth R., Luck Versus Skill in the Cross Section of Mutual Fund Returns (December 14, 2009). Tuck School of Business Working Paper No. 2009-56 ; Chicago Booth School of Business Research Paper; Journal of Finance.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, please consult with your financial advisor prior to investing.

Investing involves risk including loss of principal. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. Indices are unmanaged and may not be invested in directly.

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