In the last few episodes, we have reviewed active asset management. Unsurprisingly, passive investing takes the opposite approach to active. So what are the keys to passive investment management? Match the market return. Minimize portfolio costs. Target asset allocation to investor profile.
All that and more in Episode 39 on the Wilson Wealth Management YouTube channel.
“How can an investor ‘match the market’?”
In passive investment management, the goal is to match the market return. Unlike active management, where investors want to outperform the passive benchmark on a net return basis.
For an active versus passive basics’ refresher, please review “Episode 35: Passive versus Active Investing”.
The three keys to replicating market returns are minimizing portfolio tracking error, transaction timing, and operational costs.
The market benchmark has no cost and trades instantaneously. As a result, investors will never perfectly mirror the market return. But by focussing on these three areas, one can minimize the variance.
For additional information, please read, “Difficulties in Matching the Market”.
“What should I watch in minimizing portfolio costs?”
Portfolio costs reduce net return and impair the ability to match market returns.
This is a big reason why active asset management seldom outperforms. If an investment fund has a Management Expense Ratio (MER) of 1.5% and the benchmark return is 7%, that requires significant skill to achieve manager alpha.
The MER is a hard cost. You can readily identify it in a fund. If you are simply investing in a benchmark, then lower costs tend to be better.
However, there may be a tradeoff between things like tracking error and MER. That is why it needs to be assessed in conjunction with returns.
That said, fund costs tends to be the biggest predictor of future success. So focus on keeping costs low.
“Match market returns and minimize costs. Sounds easy. Anything else worth knowing?”
Yes.
It is relatively easy to identify individual low-cost index funds that closely match market performance.
The more difficult part is to find the correct funds in the right asset classes and subclasses. Then, hold the investments in the appropriate percentages.
Investments need to fit into the overall target asset allocation. The one you should create based on your unique investor profile. That factors in your financial situation and expectations, investment objectives, personal constraints, time horizon, and risk tolerance.
We covered the relationship between investor profiles and target asset allocation in “Episode 24: Target Asset Allocation”.
Investing based on your investor profile and target asset allocation is crucial for long-term wealth accumulation. The optimal asset allocation tends to be more important to investing success than the specific assets purchased. In fact, many studies show that the target asset allocation accounts for over 90% of the portfolio’s variability of returns.
Very important to get this part correct. Focus initially on your target asset allocation. Then fill it out with low-cost index funds in each category.
Individual investors often omit or undervalue this part of the process. Instead, they fixate on the actual investments and build their asset allocation from the ground up. A function of the investments. Rather that the target asset allocation driving the investments.
If you wish to read about this topic, please refer to, “Passive Investing Keys”.
