Is passive investing a better investment strategy than active asset management? Or, as seems intuitive, should active management provide higher net returns? Intuition is nice. But what does empirical evidence tell us in the passive versus active management debate?
“Does active asset management outperform a passive strategy?”
Some empirical studies have found that active management can produce “alpha”. That is, the managers have been able to outperform their benchmark indices in net investment returns.
“So why the debate about passive management?”
Unfortunately, there are many other studies that have found that active management does not consistently outperform over time.
If you search the internet, you will find research that suggests one or the other is preferable.
“Forget the studies. Can you show me some actual performance data?”
So, let us review some empirical data of our own. If we look at recent Morningstar data on actively managed funds in the US, some interesting inferences may be drawn.
It is indeed, very difficult, for active managers to consistently outperform their benchmarks over longer time periods.
There are a few areas where active management may be preferable. But, in general, it is hard.
In future episodes, we will discuss why achieving active manager “alpha” is not easy. And possible areas where active management may be useful.
Should you hire an investment professional to help manage your wealth? What types of investment professionals are out there? What advantages and disadvantages may exist for investors in paying for an investment professional’s services?
“What are the common types of investment professionals?”
The three professionals that individual investors usually encounter are asset managers, research analysts, and investment advisors.
Asset managers make the investment decisions. Whether that be in an investment fund or a discretionary portfolio. As an investor, you decide on the manager and then let them make all the portfolio decisions. Your only input is to invest or divest in the portfolio itself.
Research analysts review investments and recommend them for inclusion (or exclusion) in a portfolio. You may see them in fund rating services, such as Morningstar. In Yahoo Finance and other investment news aggregators. Provided by your investment broker as potential investments. You may even subscribe to analysts for proprietary information and recommendations.
Investment advisors tend to the be the actual professionals you will deal with on a regular basis. That may be a commission salesperson or bank employee. Where you receive “free” advice. It may be an advisor who charges an annual percent fee based on assets. Or, it could be a fee-only advisor. Who charges hourly or flat fees based on the services rendered.
“What are the potential advantages in working with a professional?”
There are a few typically cited.
One, a professional should have strong technical expertise. Much more than most individual investors.
Two, depending on the professional, he/she may have many years of investing experience.
Three, the professionals will have access to better analytical tools and data.
Four, it is their job. If you are a doctor, engineer, teacher, etc., you work a full day in your field. Hard to compete with a professional who is analyzing investments and strategies full-time. While you are devoting an hour or two an evening.
So, many potential advantages in working with an investment professional.
“What about potential disadvantages?”
Yes, a few of those as well.
One, as in any profession, some are better and some are worse. You need to do proper due diligence on to find a competent professional.
Two, professionals may not cover niche or neglected markets. If the professional you rely on is an expert in US large-cap equities, will they have any skills in the Western Canadian junior mining sector? Swiss small-cap domestic markets? High yield bonds? An amateur investor with expertise in niche markets may do a better job than a generalist professional.
Three, investment professionals are not free. Usually, not even inexpensive. Even that “free” advice from a fund salesperson or bank employee has fees embedded in the annual product costs. Are you getting value from the asset manager, research analyst, or investment advisor?
Four, tied in with point three, is there added value for the cost? If the asset manager charges you 1.0% per year, does he/she generate at least 1.1%? That is the key issue with investment professionals. Does active asset management provide excess returns over the cost paid by investors?
This latter issue is the age old, “Active versus Passive Management” debate. Not surprisingly, that will be the next issue we delve into.
An introduction to the age-old “Passive versus Active Asset Management” debate. What is passive investing? What is active investment management? How do they differ? What are the keys to success when implementing a passive or active investing strategy?
“What is passive investing? What are the keys to success in passive management?”
Passive investors do not attempt to “beat the benchmark”. They simply invest in the entire market.
That may be a broad market, such as the S&P 500. It may be an asset subclass. Australian mining companies. High-Yield corporate bonds. Regardless of the chosen benchmark index, passive investors just invest in the market.
Passive investors do not actively trade. They invest in the market and try to match the benchmark return as closely as is possible. Passive investors also work to minimize their investment costs.
Identify the asset class and subclass to invest in. Match the market return. Minimize investment costs.
“What is active investing? What are the keys to success?”
Pretty much the exact opposite.
Active asset managers believe they can outperform their benchmarks. That they can achieve “alpha”.
As with passive investing, the benchmark can relate to broad or narrow asset classes and subclasses.
There may, or may not be, extensive trading. Active refers more to the ability to trade and select specific investments. Not the requirement for constant buying and selling of assets.
Cost consciousness is probably nice. But active managers are primarily concerned with outperformance of their portfolio’s net returns. If it costs 2.5% per annum to actively manage an investment fund, the only issue is if the managers can generate 2.51% in excess performance.
Within the designated benchmark index, identify the “best” investments. Invest, then adjust over time as market conditions shift and/or “better” investments come along. As long as the active manager can generate “alpha”, costs are not a major concern.
Find the “best” investments. Outperform the market return. Costs, meh.
“Why the “debate”?”
On the surface, it seems obvious that active asset management should easily outperform a passive approach.
For example, perhaps my benchmark is the S&P 500. This consists of (approximately) 500 US large cap equities.
As a passive investor, I simply buy all 500 companies in their index allocation. Usually via an index mutual, or exchange traded, fund.
As an active investor, I use my professional skills and experience to analyze all 500 companies. I discard the worst 200. Ignore, or underweight, the middle tier stocks. And load up on the 25-100 companies that I consider to be superior investments. As conditions change, so too does my portfolio.
The passive investor is saddled with all 500 companies. The good and the bad. The active manager only invests in the “best” stocks.
So why is there any debate?
A professional investor who can pick and choose will outperform a passive investor all the time.
In episodes 16 and 17 on the Wilson Wealth Management YouTube channel, we looked at diversification. How properly utilizing asset correlations can improve portfolio diversification and better manage investment risk in a portfolio.
Because of this, investors often obsess in finding the “perfect” correlations when adding assets into an existing portfolio.
In this episode, we consider the following questions:
“Should investors fixate on finding the optimal asset correlation when selecting new investments?”
Asset correlation is an important consideration. But investors cannot prioritize over the quality of the investment. The risk and expected return versus other investments being assessed. Nor its fit in the investor profile and target asset allocation, so financial objectives may be achieved.
“Why do investment advisors recommend low return bonds in a portfolio? Is this part of the whole diversification issue?”
Yes. Sometimes lower return asset classes can provide effective hedges against risks inherent in some higher risk classes. But it is about the relationship between two asset classes, not necessarily a function of just finding low risk, low return investments to add to the portfolio.
“I have the optimal asset correlations in my portfolio. Is it time to sit back, relax, and reap the benefits?”
No. Correlations between assets tend not to be stable. Over time, there may be permanent shifts. As with emerging markets and U.S. domestic equities. Or, the change may be temporary. As with domestic stocks and bonds over the decades. Correlation coefficients between investments should be monitored. If necessary, portfolio adjustments may be required to re-optimize the mix.
“I have read that roughly 30 stocks can achieve useful portfolio diversification. This mutual fund has 100 holdings. That should be ample for diversification, right?”
Maybe. Maybe not. It all comes down to the asset correlations.
In episode 17 on the Wilson Wealth Management YouTube channel, we continue our review of portfolio diversification. Our focus today is on asset correlations and the real-world correlation coefficients between different investments and asset classes. Specifically:
How does the asset correlation between investments impact portfolio risk and return?
We cover a simple real world example of correlation between two global oil companies. How, even in very similar businesses, there is still diversification potential to help manage overall portfolio risk. But by adding a dissimilar asset to the mix, especially one with a low to negative correlation coefficient, the diversification benefit greatly increases.
Investopedia talks about having a “wide variety of investments” to achieve proper portfolio diversification. Is there a right number and mix of assets?
In our example, we see that the right number of assets reflects the asset correlations between the investments. The lower the correlations between portfolio assets, the less number of different investments is needed to properly diversify. The higher the correlations, the more investments will be needed to achieve useful diversification. How you build your portfolio is more important than the sheer number of assets.
Investopedia added, “that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.” Is this true?
We also see in our example that diversification does not impact portfolio return. Overall portfolio return is simply a weighted average of all individual asset returns. Whereas, the overall portfolio risk does fall as new assets are added in the mix.
However, this latter effect may allow investors to invest in higher risk assets, with higher expected returns. So, while I would not agree with Investopedia’s statement from a completely factual perspective, I understand what they mean.