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 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.
THE 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 with performance 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 the fund substantially outperformed the market, but the others in the fund performed poorly. Sometimes fund managers 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.
THE 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.
THE 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.
THE 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 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.
