The Difference Between Active and Passive Asset Management
Investment and Asset Management
What's the Best Management Approach for Your Portfolio?
When it comes to getting what you want out of life, most people would suggest that you actively pursue what’s important to you.
When it comes to investing, however, not everyone would agree that an active approach is the way to go.
Over the past few years, the battle has raged among financial pundits. Does it make more sense to pay the fees associated with active portfolio management when you might be able to achieve better returns with a lower cost passive approach?
First a Few Definitions
Active management, as its name implies, is practiced by managers who buy and sell securities in an attempt to generate better returns for investors. Actively managed investments like mutual funds seek to outperform a particular market benchmark like the S&P 500 or Russell 2000.
Passively managed investments like exchange-traded funds (ETFs) and index funds are simply those that try to replicate a market index. An ETF tied to the S&P 500, for example, will simply offer the return of the S&P 500 less (minimal) fees associated with the ETF. .
Intuitively, it might seem that an active approach makes more sense. After all, look at the benefits it offers compared to passive investing:
You’re essentially hiring a professional investment manager who spends all of his or her time monitoring markets, researching companies and making buy and sell decisions that are designed to take advantage of mispricing in the market
You may earn returns that outperform the market
You may be able to minimize losses when markets turn against you, if your manager holds higher quality securities or employs hedging techniques.
On the Other Hand...
… actively managed investments charge fees that can detract from returns. The average expense ratio for all actively managed equity mutual funds in 2016 was 1.28%, according to the Investment Company Institute. That means you pay 1.28% of your invested assets annually for management fees, distribution expenses and other charges.
Compare this figure* to the average expense ratio of passive investments. Because these investments have no portfolio managers to pay or distribution costs, their expenses are considerably lower. In fact, the average expense ratio for all ETFs in 2016, according to Morningstar, was only 0.44%.
Looking Beyond Expenses
It stands to reason that if you are going to pay more for actively managed investments, you should expect a higher return. However, this has not always been the case. As of June 30, 2016, more than 80% of large cap mutual fund managers had underperformed the S&P 500 over the previous one and three year periods. That number jumps to 90% when comparing five year returns.
So should you abandon all your actively managed investments in favor of passively managed ETFs?
First, passively managed investments enable you to participate fully in any market upturn, but they also offer equally complete participation when markets decline. In addition, some asset classes don’t lend themselves to passive approaches as readily as others. Corporate high yield bonds, for example, don’t trade as efficiently as stocks that are listed on exchanges or traded on NASDAQ. They may be subject to fluctuating supply, limited liquidity and higher trading costs that influences their pricing. In fact, several high yield bond ETFs turned in performance in recent years that bore
little resemblance to their market benchmark. Many active managers fared much better because they could research and identify purchase candidates with potentially favorable characteristics while ignoring the “junk bonds” within the market.
As a result, you might consider implementing your asset allocation with passive investments for large cap stocks and other efficient markets but consider active investments for fixed income or alternative asset classes.
Many investment professionals believe that asset allocation is by far the most important determinant of portfolio risk and performance, even more so than investment selection. Setting a proper asset allocation is important, but actively managing asset classes within an allocation can provide tremendous value. For example, global equity markets were down over 5% in the two days after “BREXIT” was announced only to have recovered within 2 weeks. Having someone who can help you not only determine when to choose active and passive vehicles but also how to actively manage across asset classes should result in a winning approach.
Whatever you do, it’s important that you don’t be passive, even if your investments are. If your portfolio has been in set it-and-forget it mode for as long as you can remember, perhaps it’s time to review your approach and determine whether it’s still appropriate. Take an active approach
and review your portfolio with your Lenox Advisor.
*Source: Morningstar data used for all calculated figures and classifications of asset class categories. Information is obtained from a variety of sources which are believed though not guaranteed to be accurate. Any forecast represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance does not indicate future performance. This presentation does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice.
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