Trends and Best Practices in Plan Investments: Active and Passive Investing

Trends and Best Practices in Plan Investments: Active and Passive Investing
Previous

The primary goal of most investors is to maximize returns and minimize risk. Although they hope for similar outcomes, investors may use significantly different strategies to achieve success. Some come down firmly on the side of active investment management, while other investors have complete conviction in passive management. Before choosing sides, you should understand both options.


Be intentional and understand the tradeoffs. That will raise the likelihood of success.

The primary goal of most investors is to maximize returns and minimize risk. Although they hope for similar outcomes, investors may use significantly different strategies to achieve success. Some come down firmly on the side of active investment management, while other investors have complete conviction in passive manage­ment. Before choosing sides, you should understand both options.

The term 'passive' in this context refers to a mutual fund or Ex­change Traded Fund (ETF) that is constructed to mirror a stock mar­ket index, like the Dow Jones Industrial Average, or more commonly, the Standard & Poor's 500 Index (S&P 500®). Strictly mirroring the selections within the index removes the active component of picking investments.

In an active fund, on the other hand, the fund manager attempts to outperform indexes like the S&P 500® by continuously evaluating the fund's investments, buying and selling, and monitoring activity within the fund. It is a much more hands-on approach, requiring more time, effort and skill than passive investing.

Many experts say that passive investing yields better results, and they point to studies that support their contention. Other experts support active management, because passive investors are unlikely to ever obtain investment returns that exceed the index, therefore missing out on potential upside returns. If both sides offer valid arguments, how can investors decide between the two approaches?

Maybe they shouldn't…

A hybrid approach, one that uses the best elements of a passive strategy combined with those of an active strategy, is worthy of consideration.

Taking an active approach

As an active fund manager seeks to outperform the market, he or she must thoroughly research the investments available within the fund's targeted asset class(es). It's a labor-intensive process, requiring a deep understanding of financial markets, industries, and individual companies. The active fund manager spends a lot of time gathering pertinent information and making the trades he or she believes will result in the highest returns. The manager is paid for the time and effort involved, and that results in higher investment fees.

The rewards may also be higher. When the fund manager makes the right selections, the fund should generate substantially higher returns than its passive brethren.

Taking a passive approach

Passive investing strictly follows a selected index. It doesn't require the same level of skill or time commitment, so the fees are substantially lower than they are for an actively managed fund. Because the passive fund follows an index, the investment returns will generally be similar to the performance of the index as a whole (before fees).

The trick, then, is to decide if the additional investment earnings that come from active management are high enough to pay the addition­al fees and still net better returns for the investor.

A hybrid strategy that includes both passive and active investing includes the best of both worlds. By being selective and using each method in the right circumstances, investors may benefit from the strengths of each, while limiting unintended consequences, like paying for active management while only receiving passive (or lower) returns. In order to be effective with this combination, it is important to understand when to use each strategy, and how they may complement one another.

Among the subtleties your investment advisor should understand and apply:

MARKET OPPORTUNITY. There is often more opportunity for active management in certain asset classes during times of market volatility. Active managers tend to outperform the indexes during downturns. For instance, during the market downturn of 2001-2002 and again in 2007-2008 active managers often outperformed the market. In contrast, passive funds have performed better than active funds in the last few, relatively calm years. As the markets become more volatile, including during times of negative returns, active man­agers may generate higher returns.

REGIONS' VIEW:  New research allows our portfolio managers to better understand the indicators of these market opportunities, and strive to take advantage of them by tactically investing to a greater extent in actively managed funds during turbulent times.

APPROPRIATE RESEARCH. Investment performance is past tense. When choosing a fund manager, the decision should not be based upon surface statistics. It is important to avoid funds whose per­formance is based solely on the luck of the fund manager. A close examination of the fund's year-by-year performance will reveal if the fund enjoyed a single year of stellar performance that overshadowed nine more years of underperformance. Or, perhaps one of the five holdings in their fund substantially outperformed the market, but the others in the fund performed poorly. Sometimes a fund manager will closely track an index because they know they can generate returns that are adequate, but don't rise to the level of active management, or reach its potential.

REGIONS' VIEW: By looking beneath the surface, we seek managers whose past performance demonstrates more than a lucky streak. We choose those we believe have a strong likelihood of performing well for our clients.

PERSISTENCE. Another word for persistence is patience. The choice of funds in a client portfolio should be based upon research and use a clearly defined process. Emotion should not be a part of the decision. With that commitment there should be a recognition that even the best fund manager will not outperform every year.

REGIONS' VIEW: We put in the time up front to scrutinize the funds and managers under consideration. Once that process is complete, we avoid giving in to emotion, sticking to our choice until our process tells us it is time to make a change. Our investment strategy is designed with a long-term view.

Open architecture makes it work

Open architecture means that an investment firm may select from the universe of funds available in the market, without limitations set by proprietary ownership. Firms that use only their proprietary funds must select only from those funds, unable to look outside for a fund that is a better fit or that has more promise. When open architecture is used, the choices are abundant. While this means the portfolio manager is free to choose what he or she views as the best options from a prescribed group, the need for due diligence research is also greater.

REGIONS' VIEW: When a firm must choose from among only its own funds, managers may be more focused on the firm's business than on the clients' investments. At Regions, we utilize an open architecture platform that allows us complete flexibility to select the most appropriate funds for our clients.

Our Portfolio Management Group is very intentional in the decisions we make about the use of active and passive investments. We watch market indicators and use our best judgment and training to deter­mine when to use each strategy. Our guidelines and processes are based upon experience and analysis, not emotion.

It's important to us that our clients understand the tradeoffs involved in choosing an investment strategy. That's why our policies are clear­ly articulated, and we work with plan sponsors to educate them and their participants about those tradeoffs. We want our clients to un­derstand our expectations for a selected fund, and avoid puffery and gimmicks that may serve only to increase investment fees. We're in it for the long-term, and want our clients to be as well.

This focus is particularly important in the defined contribution plan arena, as it is incumbent upon plan sponsors to ensure fees are reasonable. When they consider complementing a low-cost, passive investment strategy with active strategies, it can enhance total re­turns while still maintaining an overall low fee outcome.

Next

On a scale from 1 to 5, with 1 being 'Not Good' and 5 being 'Excellent', how would you rate this article?

Press enter to submit your rating

Rate this Article

Use this form to provide additional feedback based on the rating you provided.

Thanks for Rating

Would you like to provide feedback?

Thanks for your feedback!

*Investment, Annuities and Insurance Products

  • Are Not FDIC Insured
  • Are Not Bank Guaranteed
  • May Lose Value
  • Are Not Deposits
  • Are Not Insured by Any Federal Government Agency
  • Are Not a Condition of Any Banking Activity

The content and any portion of this newsletter is for personal use only and may not be reprinted, sold or redistributed without the written consent of Regions Bank. Re¬gions, the Regions logo and other Regions marks are trademarks of Regions Bank. The names and marks of other companies or their services or products may be the trademarks of their owners and are used only to identify such companies or their services or products and not to indicate endorsement or sponsorship of Regions or its services or products. The information and material contained herein is provided solely for general information purposes. Regions does not make any warranty or representation relating to the accuracy, completeness, or timeliness of any information contained in the newsletter and shall not be liable for any damages of any kind relating to such information nor as to the legal, regulatory, financial or tax implications of the matters referred herein. This material is not intended to be investment advice nor is this information intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only current as of the stated date of their issue. Regions Wealth Management is a business group within Regions Bank that provides investment, administrative and trustee services to customers of Regions Bank.

Neither Regions Bank nor Regions Institutional Services (collectively, “Regions”) are registered municipal advisors nor provide advice to municipal entities or obligated persons with respect to municipal financial products or the issuance of municipal securities (including regarding the structure, timing, terms and similar matters concerning municipal financial products or municipal securities issuances) or engage in the solicitation of municipal entities or obligated persons for such services. With respect to this presentation and any other information, materials or communications provided by Regions, (a) Regions is not recommending an action to any municipal entity or obligated person, (b) Regions is not acting as an advisor to any municipal entity or obligated person and does not owe a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934 to any municipal entity or obligated person with respect to such presentation, information, materials or communications, (c) Regions is acting for its own interests, and (d) you should discuss this presentation and any such other information, materials or communications with any and all internal and external advisors and experts that you deem appropriate before acting on this presentation or any such other information, materials or communications.