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Active vs. Passive Investing


April 22, 2013

One of the hot topics in investment circles these days is the issue of active versus passive fund management. Active management has been around the longest. A fund is actively managed when it is run by a manager or management team, supported by some researchers and administrators. The fund management tries to find the most promising investments in which to invest and then manages the portfolio of investments per the prospectus, buying and selling at optimum times. Usually the fund’s performance is measured against an appropriate index. If the fund out-performs this index, it is bonus-time. When the fund lags its index regularly, it may be pink-slip time.

Passive investment occurs when the fund sets as its performance goal to match that index. Life becomes very simple. Whatever the index invests in is what the fund invests in. No research required. No portfolio management required. When a company is dropped from an index, the fund manager sells the fund’s holding. When a company is added to the index, the fund manager buys an appropriate amount. Not a very challenging job. Appropriately enough, the Vanguard Fund Company was in the vanguard of the index fund movement. The Vanguard Index 500 mutual fund was and is one of the largest mutual funds around. Its manager also managed about a half a dozen other funds to fill his workday. Obviously, index funds should have really low expense ratios. Lower than whale dung!

Index funds proliferated, as did actively managed funds. There are many more mutual funds than there are listings on the New York Stock Exchange. There are places for both index and actively managed funds in most investment portfolios. There are seasons when active management excels and others when passive has the advantage. Stock index funds excel when the stocks move “in synch”, such as has happened lately as stocks recovered from the 2008 great recession and accompanying bear market. “A rising tide raises all boats.” When stocks move together, the funds with the lower expenses win.

Actively managed funds win when human judgment and research is required. Actively managed funds also win when fund management requires flexibility and quick reaction to changing market events. Small company and global stock funds usually need active management.

In their marketing, index funds point out that the average fund manager does not beat his index. True. If I am an average fund manager and I also have to pay my average research staff and a hefty travel bill as I run around the world looking for good investments, I will lag my index, which has no such costs.

But there are many “above average” fund managers out there with their above average research staffs who have beaten their index during most years. They buy out-of-favor stocks low and sell high. With a little research, these funds can be identified. But if one wants to settle for “average” an index fund is a good way to go. Maybe.

Why the “maybe”? Lately, passive investing has received a huge boost with the proliferation of Exchange Traded Products (ETP’s) which resemble index funds except they can be traded like individual stocks. There are now close to 1500 ETP’s with over a trillion dollars in assets. They still have the disadvantages and advantages of index funds.

This proliferation of index products changes the investing landscape appreciably. How the markets will react when problems surface is very problematic. No one really knows. Now, when a company is placed into a popular index, the share price is likely to take a big jump up just due to simple supply and demand. So when you buy an index fund, you are likely buying high.  Conversely, woe be unto the stock of a company that is dismissed from a popular index. And what happens when some market crisis occurs, such as the Enron accounting scandal? All of the index products that hold the problem company cannot sell until the stock is dropped from the index. Active managers would likely sell as the problems surfaced.

We at HSC Wealth Advisors are using some ETP’s but are not over-committing. We want to see how the markets react to varying conditions. Our task is not only selecting good funds, but organizing them into diversified portfolios that will accomplish your goals. We still have to strategically allocate (how much stock vs. bond exposure) and tactically allocate (how much small company, large company, international, passive and active, etc.). We also need to determine how much of the various elements of your portfolios should be rebalanced and when.

Some things have changed. Many have not. Stay tuned.

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