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Active vs. Passive: Not either/or

Key & MoneyBy Tom Pappenfus

A growing debate among investors is whether active fund managers can do a good enough job of picking stocks to regularly beat the market. Waves of advertising and marketing, especially from no-load mutual fund families and online discount brokers, would suggest that passive index investing is the way to go.

Judging from the flow of money to funds, many investors are latching on to this message. But the pitch for index investing focuses merely on returns. It ignores risk.

As an investor, you need to be concerned not just about the return on your money but the return of your money. Active management can let you take below-average risk for near-average returns. All you get with indexes is average risk for average returns.

A big argument for active management has to do with risk management. Passive index investing won’t manage risk the way a portfolio manager can. Investing along the lines of an index will give you index risk but less than index returns after netting out fees.

Fund managers, with active selection, can incorporate strategies to introduce negatively correlated investments to manage risk and possibly stabilize returns. There are good fund managers with great resources, expertise and teams of analysts that can find values and outperform market indices – if not in the near term, then over the long run.

Less risk, more return
Read Kyle Tetting’s article on research showing how active management can beat index performance and take less risk.

In almost any given year, you can find mutual funds that beat their benchmark index. Our job as independent advisors is to filter down and discover the fund managers who do the most consistent job of that.

Active and passive strategies tend to perform differently in different economic and market environments.

In 2014, we saw stock returns with low dispersion, meaning there wasn’t much difference in returns from the lowest performer to the highest. That makes it more difficult for fund managers to find stocks that are outperformers. But when there is greater volatility, market corrections, mis-pricings and interest rate movement, investors should expect to see the stock pickers’ experience at work.

Investing in a passive fund that tries to mirror an index is a sort of “if you can’t beat ‘em, join ‘em” approach.

John Bogle, the founder of Vanguard, is considered the godfather of passive or index investing.  He wrote the book “Common Sense on Mutual Funds” to drive home his main point that portfolio managers in general can’t consistently beat their benchmarks and that investors should all save on the added cost of an active manager and just invest along the lines of an index.

Increasingly, the low-cost accessibility of Exchange-Traded Funds (ETFs) is appealing to do-it-yourselfers because it’s easier to understand following an index than trying to research mutual funds and their managers.

The real answer to the question of active vs. passive is not a simple matter of either-one-or-the-other. Investors can benefit by having both actively and passively managed funds in their portfolios.

When investment advisors break down asset categories into more specialized segments to review performance more closely, we can see where managers have a more difficult time beating their benchmark index and areas where they can add great value.

For instance, the expertise of fund managers can pay off in picking investments in areas such as international stocks, bonds and small- and mid-cap stocks. On the other hand, if there seems to be little value added in the research and experience of a manager, we may employ the passive strategy to just reap the returns of broad exposure to an area such as large-cap stocks.

By strategically using both active and passive approaches, investors can take advantage of greater market expertise where it counts most and still cut down on costs with selective index-based investing.

Tom Pappenfus is a registered representative and investment advisor at Landaas & Company

(initially posted Jan. 26, 2015)

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