Rick Welch: Dollars and $ense

Active and Passive Investing….Together

Since I last wrote on this topic in early 2013, we have seen that an accommodative Federal Reserve (and zero bound interest rates) while generally supporting asset prices can also dampen stock price volatility and subdue both economic and corporate earnings growth. As stock prices have continued to grind higher, we see in the background higher or tightening correlations between asset classes. As defined, “correlation is a measure of how prices of two types of investments move in relation to each other.” When correlations between asset classes tighten it is more likely that stock price movements of different assets will be similar in size and direction, and such conditions might indicate that a passive strategy is preferred. Passive strategies essentially aim to replicate the broader market’s performance rather than beat it. In contrast, active strategies aim to outperform their benchmarks by making smart security selection decisions. Expansive fiscal policies (tax reform and infrastructure spending) coupled with tightening monetary policy (rate hikes) may provide better future opportunities for active stock selection. While it is clear that active and passive investment strategies are both legitimate and fundamentally sound techniques, our work has shown that asset allocation models that blend both passive and active strategies will generally outperform strategies that focus on one or the other.

The easiest means for most investors to benefit from active professional management is to purchase shares in a mutual fund. A mutual fund is an actively managed fund with day-to-day managers who buy and sell securities according to a plan which designates a specific purpose, style or category. For their services, the managers of the mutual fund are typically paid a fee which might range from 0.5% to 1.5%. In addition to the professional active management, mutual funds offer the potential to beat the performance of the overall market and can be used to diversify any portfolio. Most investors would be surprised to learn that each year over 80% of actively managed mutual funds fail to beat the average return of the stock market or even the applicable benchmark index.

I like to think of an ETF or exchange traded fund as a collection or basket of assets that is designed to replicate the performance of a segment of the market. Think of an ETF as a diversified portfolio that holds assets related to a specific market, industry sector, country or region, or a commodity without the cost and effort involved with buying all of the individual assets separately. ETFs are set and maintained according to plan which is typically a specific index or benchmark and the plan is not altered during rising or falling markets. ETFs offer good diversification, are transparent, trade like stocks and charge much lower fees than mutual funds. When you purchase an ETF that is aligned with a specific index, at the end of the year the performance of your ETF should be about the same as the index, good or bad.

The argument of active versus passive investing is really about cost. What is the best way to build a portfolio that maximizes expected risk-adjusted return while minimizing cost? How you build that portfolio is an active decision. Low cost ETFs may offer advantages over mutual funds during certain periods of time or for particular segments of the market. Mutual funds may make sense when the market is moving more quickly and winners and losers (either individual stocks or segments of the market) are easier to identify. Why should we have to choose between active and passive? I think that the optimal approach to investment management is the marriage of both styles.

 

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