Your Investments: Passive versus active investing

When it comes to investing, there are two approaches that one can choose to implement: a passive investing approach or an active asset-management approach. Let’s take a look at each method and try and figure out which is best.

Definition

Passive investing generally means that the amount of buying and selling is limited, or virtually non-existent. The intention of each investment is to be held for the long-term, and not try and cash in on short-term profits. It is also known as indexing or a “buy and hold” strategy. There are many advantages to this style. Limited transaction costs, more tax efficiency and lower management fees are just some of the advantages.

Proponents will say that since most portfolio managers are able to outperform the broader market, there is no point in trying. Instead, they suggest you just buy either good-solid companies or track market indices with index funds or Exchange Traded Funds (ETFs), claiming that that is the surest and cheapest way to ultimately profit.

Active investment management, on the other hand, is defined as an attempt to “beat” the market as measured by a particular benchmark or index. The S&P 500 Index is an example of an index that gauges the performance of the large-cap US stock market – known as “blue chip” stocks.

In an actively managed portfolio, the investment manager uses a whole host of criteria to help make investment decisions.

Managers may incorporate market trends, economic data and political events, as well as the individual situation of a specific company, within his decision. The goal of active fund management is for the investor to try and outperform the specific index to which he is comparing himself.

Which works best?

Investors always want to know which method is the best. It’s like trying to decide between Coca-Cola and Pepsi. Both sides are able to make logical arguments to defend their favorite approach. The proponents of passive investment generally believe that it is difficult to beat the market. They therefore believe that if it’s so hard to outperform the general market, it’s best to link yourself to the broader market indices and let the market do the work for you.

Conversely, active managers believe the market can be beaten.

By buying and selling, they believe that they can take advantage of the irregularities in the market that can help produce superior returns. Unfortunately for them, data seems to show that in most cases they don’t succeed in producing superior returns, certainly not over the long run.

In what could be considered rather ironic, it is the low cost of the passive approach that can end up hurting returns.

Research has shown that investors tend to “over trade” low-cost ETFs. Robert Powell of Marketwatch.com quotes David Zuckerman, chief investment officer at Zuckerman Capital Management, as saying, “Research has shown that ETF investors tend to trade much more frequently than investors in similar open-ended mutual funds, and studies have shown that high portfolio turnover hurts returns.”

Big help there, right? It’s just that there is no empirical answer. I actually like to use a blend of both strategies, where the core or base portfolio is more of a low-cost buy-and-hold approach, and overlay certain strategic investments to try and generate more value.

The one thing that I need to stress is that for investors with long-term investment horizons, it’s important to realize that both strategies will have their good times and their bad times.

Individual investors should try to ignore the trend of the moment, and stick with just one strategy.

I can’t begin to tell you how many people I have met that jump from one strategy to the next. They are the ones who end up losing. If you stick with a strategy, your chance of success is much higher.

As I’ve mentioned in previous columns, creating your asset allocation – the mix of stocks, bonds and cash in your portfolio – is the single most important task you can perform as an investor. Many studies have shown that the proportion in which you hold stocks, bonds and cash has a greater effect on your portfolio’s returns and its volatility than the individual investments you choose.

Aaron Katsman is a licensed financial professional both in the United States and Israel, and helps people who open investment accounts in the United States. Securities are offered through Portfolio Resources Group, Inc. a registered broker dealer, Member FINRA, SIPC, MSRB, SIFMA. For more information visit www.aaronkatsman.com, call (02) 624-0995 or email: aaron@lighthousecapital.co.il.