Post updated on: 07.01.20
Portfolio design with either active or passive investing styles is one of the great investing debates today. Most of the finance experts and money managers are usually passionate on one style or the other and invest their clients’ nest egg with their preferred style. If your money manager is an active style portfolio manager, he or she probably won’t build you a portfolio based exclusively on index funds. If your money manager is a passive manager style, you probably won’t see individual stocks in your portfolio.
What philosophies are each of these styles based on and what are the pros and cons? In a previous blog post we explored brief investment style history that has led up to the great active vs passive debate. With that as background, let’s go a little bit deeper on each of these and explore a couple of hybrids.
Active Portfolio Investment Style
Active investment style involves the on-going buying and selling of assets to maximize the portfolio’s return. The active financial analyst uses either technical analysis (market analysis) or fundamental analysis (company financial profile analysis) or a combination of the two. The goal is to search for the growth or value stock and buy it at the ‘right’ time and sell it at the ‘right’ time. The goal is to profit from short-term price fluctuations, in other words, “timing the market.”
The advantages of the active investment style include:
- Your portfolio is analyzed proactively
- An expert money manager may potentially bring you greater returns (but only if they have a superb technical or fundamental analyst on staff)
However, there can be many downsides of an actively managed portfolio:
- More transactions mean higher transaction costs are being paid
- Usually a much larger percent of your total assets goes toward the money manager (between 1 and 1.5% of the total assets under management (AUM) is the typical yearly fee)
- Potential tax implications of the assets being sold
- It has been increasingly difficult to find money managers that can consistently outperform the market
That last bullet is what is leading many investors to look for other options. “Why should I pay a money manager a 1%+ AUM fee if they can’t beat the market on a regular basis?” is a common gripe amongst everyday investors, especially high net worth investors who may end up paying tens of thousands of dollars per year for investment management services. This is the core reason that many investors turn to either do-it-yourself (DIY) investing, utilize a robo investment house, or look to a fixed flat-fee investment manager.
Passive Portfolio Investment Styles
Buy and Hold Using Specific Equities
Buy and hold generally means to buy a set of assets and hold them indefinitely. Generally speaking, the assets would be a set of stocks in an undiversified portfolio. For example, if someone has an affinity toward a certain stock(s), they may invest in that stock(s) and hold it indefinitely whether it goes up or down. They may also collect a nice dividend along the way. In that example, the intention is to reap the reward of the consistent dividend. The buy and hold style may work for some people some of the time, depending on their circumstances and requirements.
The downside of buy and hold is selecting the right stocks can be hit or miss. You may be gaining a small dividend, but potentially giving up diversification within your portfolio which may actually slow your growth and expose you to more risk.
Buy and Hold Using an Indexed Portfolio
An alternative passive investment style is to ‘buy and hold’ an index fund. An example is a mutual fund that tracks to a specific market index, such as the S&P 500. Such a mutual fund is called an index fund. ETFs can also be used to track an index. The advantage of the index fund strategy is the exposure to many more stocks which reduces the risk from a buy and hold strategy of a limited number of stocks.
Using the example of the S&P 500 benchmark index, an investor would select one of the
dozens and dozens of mutual funds and ETFs that are available in the marketplace that closely tracks the S&P 500. Then buy and hold that index fund for the long term.
Now to complicate things, the S&P 500 only consists of U.S. large cap stocks, not the other major asset classes such as small cap, mid cap, bonds, etc. There are many more benchmark indexes than the S&P 500. There are indexes that track different industries, different types of stocks, different geographies, currencies, etc. An indexed portfolio can contain more than one index fund that would track some of these other benchmark indexes. In fact, doing so is recommended and will help with diversification to spread out the overall risk of the portfolio.
The advantage of the indexed portfolio investment style is that over the long-term, generally, the benchmark indexes have done very well. By selecting a few well-diversified index funds, you can have a potentially very well performing portfolio over the long term. Also, the myriad of index funds that are available has extremely low cost, which boosts the overall performance of the portfolio.
The downside is that if your time horizon is short-term, you could suffer from the decline of the benchmark index(es) that your portfolio is designed to track.
Please note that the performance of portfolios, ETFs, or other products will differ from the performance of their respective index for various reasons, including:
- ETF Costs
- Management Costs
- Trading Costs
- Implementation Risk
- ETF Tracking Error
There are a couple of hybrid strategies that may be very effective for many investors. One involves a combination of a
Indexed Portfolio with Active Portfolio Management
By constructing a portfolio that is properly diversified and correlated to multiple global indexes, you can diversify away much of the non-market risk (systematic risk). Doing so can smooth out some of the ups and downs you will get with a single index fund. That is the essence of the 7Twelve® philosophy, a trademark approach for developing a well diversified, low correlated portfolio.
The process to develop the overall best portfolio is very involved, hence active portfolio management. A general methodology for developing a diversified portfolio consists of the following:
- Understand your goals, objectives, time frames and risk tolerance levels
- Select a set of benchmarks to design the portfolio
- Evaluate the myriad of index funds or ETFs that can best track the benchmarks (for example, which mutual funds or ETFs are best for the investor)
- Properly weight, diversify and correlate the various assets
- Monitor regularly
- Rebalance as appropriate
Once the portfolio is designed and in place, then it is a matter of regular monitoring and rebalancing on a regular basis. I generally recommend the monitoring and rebalancing adjustments either quarterly or yearly. The suitable review time frame for you depends on your own unique circumstances and requirements.
The advantage that the passive indexed portfolio has with active portfolio management includes:
- Portfolio tailored to your best interest and risk tolerance
- Lowest cost structure due to the use of index funds and ETFs (some as low as .05%)
- ETFs may be more tax-friendly depending on the portfolio mix
- In many cases, may outperform the active investment style approach
- Regular interval feedback on portfolio performance
With so many advantages you may wonder what the downsides are. With better possible performance in the short-term, long-term AND with lower fund costs, there really isn’t much of a downside. The only downside may be the cost of hiring a finance expert to develop your financial plan, investment strategy, and occasional portfolio monitoring. But that cost may likely be offset by the overall gains and peace of mind.
Often times the question about index strategy investing comes up, “How do you beat the index?” One strategy to beat the index that is an active approach is to leverage the factors that may tilt certain stocks within an index, such as the S&P 500.
The fact is, there are large disparities across factors within the stocks in the S&P 500. A factor-based strategy provides the money manager an opportunity to capture higher returns than the index.
Common attributes, or factors, of an individual stock may include:
- High Momentum
- High Quality
- High Value
- Low Volatility
These factors can be measured and tracked. Doing so gives the money manager a way to “tilt” the portfolio towards those equities that are performing well. In other words, placing more emphasis on certain stocks. Then when the factor dynamics change, the money manager can rotate to a different tilt in the portfolio.
A good analogy is comparing SpaceX to Boeing. Both wanted to build the technology to get to the International Space Station first. Boeing, seemingly, had the advantage because of the company history and strong legacy in aeronautics. But SpaceX, being brand new, had no such legacy or expertise. But SpaceX did have a new approach to outperform Boeing. Which it did. SpaceX beat Boeing’s tried and true approach and docked with the International Space Station earlier this year.
Factor Rotation may be the strategy you are looking for to outperform the standard index fund approach.
Portfolio Design – Why it Matters
The bottom line is you can’t predict or control the performance of the market, but you can predict and control the FEES that you pay in your funds! That is the major advantage of using index funds and ETFs. Even a half percent lower fee over the long term can add several hundred thousand dollars to your nest egg.
When you couple the passive investment style with active portfolio management, you are gaining the best of both worlds – leveraging the lower fees and actively managing your diversification and correlation to minimize risk within the portfolio.
Actions You Can Take
Start by writing down your personal and financial goals, the risk you are willing to take (how much you are willing to lose), your overall purpose in life, the specific goals you would like to achieve (short, medium and long-term), your income, assets, and debts. Make an attempt to create a personalized Investment Policy Statement for yourself. Then seek out a qualified professional to help you come up with your personalized financial plan. Your investment plan should be a key component of your overall financial plan. Look for a fee-only financial planner to give you an unbiased assessment of what strategy and investment funds are best for you.
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