Should you use an active approach with your portfolio? Coke or Pepsi? Vanilla or chocolate? Tom or Jerry? Believe it or not, the world of investing also has its own argument of preference. When it comes to investing, there are two approaches that one can choose to implement: active or passive. Let’s take at look at each method and try and figure out which is best.
Active or passive
Active investment management 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 large-cap US stocks, known as blue-chip stocks.
In an actively managed portfolio, the investment manager uses various criteria to help make decisions. Managers may incorporate market trends, economic data and political events, as well as the individual situation of a specific company. The goal of active fund management is for the investor to try and outperform the specific index to which he is comparing himself.
Passive investing generally means that the amount of buying and selling is limited, or virtually nonexistent. 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 a “buy and hold” strategy, or indexing. There are many advantages to this style, including limited transaction costs, more tax efficiency and lower management fees.
Proponents will say that since most portfolio managers are unable to outperform the broader market, there is no point in trying, and you should just buy either good, solid companies or track market indices with index funds or exchange-traded funds (ETFs), and that’s the surest and cheapest way to ultimately profit.
Which works best?
Both sides can make logical arguments to defend their favorite approach. The proponents of passive investment generally believe it is difficult to beat the market. They therefore believe 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 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 the low cost of the passive approach that can end up hurting returns.
Research has shown that investors tend to “over-trade” lowcost ETFs. Robert Powell of Marketwatch.com quotes David Zuckerman, chief investment officer at Zuckerman Capital Management, who said: “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.”
The middle road As usual, the answer may lie somewhere in the middle. I like to use a blend of both strategies, where the core, or base portfolio, is more of a low-cost, buy-and-hold approach. Then I overlay certain strategic investments to try and generate more value.
It’s also very important that as you approach retirement, or certain costly life-cycle events are fast approaching, your portfolio needs to change to fit your new financial reality. Often, proponents of the passive approach end up with portfolios far too aggressive than they should be because they have never made any changes and have the same allocation they had 30 years ago.
The one thing I need to stress is that for investors with longterm 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 who 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, or the mix of stocks, bonds and cash in your portfolio, is the most important task you can perform as an investor.
Many studies have been conducted that show 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.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc., or its affiliates.
firstname.lastname@example.org Aaron Katsman is a licensed financial professional in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.