Whether active management of a portfolio can actually produce better investment results than a passive portfolio has been a long-standing argument in the investment community. And, given the recent history of market volatility, this conversation has moved even more to the forefront.
What is Active? What is Passive?
An actively managed portfolio uses the skill of a single manager or team of managers who employ technical analysis, fundamental research and personal judgment to determine which investments (we’ll use stocks as our example throughout this article) to buy and hold or to sell within a portfolio. The manager(s) typically operates within a specific discipline (large cap growth, small cap value, international, etc.).
Those who subscribe to the active approach to money management do not buy into the efficiency of markets. They believe there’s enough inefficiency and imperfect information to make it possible to profit by identifying mispriced (either too high or too low) securities and taking action (buy and hold or sell).
On the other hand, subscribers to the passive approach (also be described as “indexing”) believe that markets are efficient and that all information that is available on a specific stock is known and built into the price of the security. These folks believe that in the long run, parking money in an index, such as the S&P 500, will yield better investment results than actively trading and picking specific stocks within the index will yield.
The argument for passive investing becomes even more compelling when you consider how the management fees and trading costs inherent in the actively managed portfolio can drag performance down.
Of course, it’s also possible to be an active trader of passive investments, such as exchange-traded funds (ETFs). These have become wildly popular with good reason: EFTs are low cost, liquid and are easily traded like a stock. An ETF can be tied to one asset, such as gold, or to a group of assets, such as dividend-paying stocks.
What’s sometimes missing from the passive vs. active conversation, though, is the notion that, according to the widely accepted 1991 study by Brinson, Singer and Beebower, asset allocation of a portfolio accounts for 91% of the long-term performance of a portfolio, and market timing and stock selection are considered to have far less impact.
Even if you choose the passive route, it’s unwise to think you can put all your eggs in one basket (or, in our case, in one index) and think you’re assured long-term success.
In other words, diversification – choosing the right mix of asset classes – is a far more powerful influencer of investment returns than is hiring money managers, using indices or employing a combination of both. This holds true whether you’re talking about large, medium or small companies, domestic or international, developed or emerging markets, traditional asset classes or alternatives – just to name a few.
Of course, with so many investment products and solutions available, even self-proclaimed passive investors need professional advice to get it right.
So……..is Passive the winner or is Active the winner? In our opinion, a combination of both approaches is the best strategy. Making tactical changes between asset classes as economic conditions change and markets adjust can help to achieve the proper asset allocation to maximize risk-adjusted returns.
Also, don’t forget that the “right” portfolio or asset mix doesn’t come in one size fits all. Rather, “right” is whatever is ideal for you at this moment – which means you’ll need to revisit your portfolio or asset mix whenever your life circumstances change.