Active & Passive Investing Explained

Investors should have a defined methodology to portfolio management. There are 4 broad steps each investor should undertake:

1. Decide how much money to invest

2. Choose an asset allocation

3. Decide how the portfolio should be monitored and adjusted over time

4. Select a framework for buying specific investments

Financial advisors typically fall into one of three camps regarding #3, which is what this post will explore.

The first camp of advisors selects money managers who manage the portfolio with frequent trading in an attempt to time buys at price bottoms and sells at price peaks. They may execute this strategy with individual stocks or on a more broad level with Asset Classes. Both methods are forms of market timing.

Money managers utilize analytical research, forecasting, and their own judgement to select which investments to buy, sell, or hold. These managers believe they can identify mispriced investments which will outperform the general market. Generally, their process ignores the Nobel Prize winning Efficient Market Hypothesis; that the price of stocks continuously reflects accurate pricing and you can't beat the collective wisdom of millions of other investors.

This highly involved strategy generally costs more, and capital gains on larger account balances can create a tax drag for investors. Almost all mutual fund managers subscribe to this style of investing.

It's called Active Management.

Passive Management takes a distinctly different approach. The passive camp subscribes to a buy and hold strategy, generally through a highly diversified portfolio built with Index Funds. These funds mirror a pre-determined, broad-based basket of stocks. Most of us are already familiar with the S&P 500 Index. The stocks in this index represent a diversified cross section of medium and large U.S. companies across industry sectors such as finance, tech, and healthcare.

Because passive management steers investors clear of frequent trading, costs are almost always lower and the portfolio is typically very tax efficient. Passive investing enthusiasts avoid the risk of underperforming the market, something they're quick to point out to active investors.

The tradeoff to passive management is the investor will never beat the market, something the active investors throw right back at passive investors. Passive investors are ok with this. They think market timing is futile, and simply accept what the market delivers.

The last camp involves a portfolio strategy that combines active and passive strategies. This style typically uses passively managed funds as a core, with active management employed in "less efficient" asset classes such as Emerging Markets- Brazil, India, Russia, China to name a few.

While there is Some Research suggesting pricing anomalies have existed in emerging markets, it's a whole other story as to whether a money manager can actually exploit these mispricings to achieve market beating performance net of trading costs.

Research firms like Morningstar and S&P Indices keep track of fund manager performance. S&P Indices Most Recent Scorecard reported that 92.19% of managers in the emerging market space failed to beat their 10-year benchmark (page 10 of the previous link). Morningstar just released Similar Findings.

There is an overwhelming wealth of Evidence Dating Back Six Decades that very clearly demonstrates it's impossible to consistently outperform the market. Further, how could it ever be possible for a financial advisor to somehow be smart enough to select a money manager who'll deliver market beating returns in the future?

I find it strange when advisors tell me they use both passive and active portfolio techniques. Several of them subscribe to this blog; they'll probably throw rocks at me next time we connect. However...

A colleague and great friend of mine recently put this combo strategy into perspective. Using both active and passive strategies "allows the advisor to admit with one side of his/her mouth that a strategic (passive) allocation makes the most sense as markets aren’t predictable, but right out of the other side promise to add value in some manner by making tactical (active) moves with some other part of the portfolio. Either markets are unpredictable over or they aren’t. Either you know what is coming next or you don’t. What is the point of saying you know what is coming next, but only for a portion of the portfolio? If you really knew, wouldn’t you be all over that?".

I'm highly interested in the concept of outperforming the market. Disclaimer: I also like unicorns, UFOs, and Sasquatch. Seriously, I do think it's amazing that history has produced a select few managers who've possessed extraordinary skill. Unfortunately, statistical analysis has proven most Outperformance Is Pure Luck . Even the most brilliant money manager's winning streaks eventually come to an end. It's investors Chasing This Past Performance that continue to get burned.

I'll admit when I know what I don't know. I acknowledge there are some things I don't even know I don't know. What I do know is there is no documented, peer-reviewed process in finance to consistently beat the market with active management strategies over the long run.

Investors may not like the name passive investing because it implies we're not trying. Boring as it may be, passive investors have historically come out ahead of the market timing antics that define active management. Until that changes, investors should stack the odds in their favor with a passive approach.

Yes, I'm biased.

#evidencebasedinvesting #indexfunds