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Balancing active management & passive management

Posted by admin on March 3, 2010 in Investment Information

Life has little absolutes- death, taxes and change come to mind- but, yet, the discussion between active management vs. passive management assumes that one absolutely has to be in one corner or the other. Either one is an active portfolio manager in an attempt to outperform the market or one makes as little decisions as possible by tracking broad based equity and fixed income indexes.

However, life is not that simple. Few investors start with a combination of a blank slate and adequate cash to begin an purely active and passive management approach (and how lucky are you if you have both). Others, like me, have to wait out early redemption penalties before selling mutual funds, leading to an in-transition portfolio.

As Rob Carrick pointed out recently, institutional investors do engage in both active and passive management strategies as a way to mitigate against the downside risks of both approaches.  Carrick suggests that retail investors adopt a similar strategy by dividing their assets 50/50 between both approaches.

For institutional investors employing a mixture of both strategies, what are they actually doing? A recent surveys reveals that pension funds were passively managed when it came to U.S. equities but  active managers on non-U.S. equities (up to 75%).

This suggest when it comes to broad based equity markets, such as the S & P 500, where there is depth in quantity and quality of publicly listed companies, it is a fool’s errand to believe one can pick a winner from a loser.  One may be better off picking them all via a broad based index.

In smaller exchanges, with relatively less transparency, lack of shareholder rights and lack of quality on any given exchange, institutional investors may be trying to separate the wheat from the chaff.

What does this all mean for you and I?

1. Start from the assumption there is no objectively absolute “right” way to invest. I agree with passive investors and active investors- if it works for them. The concept of a “right” way to invest comes down to life-style, skill, experience (in life and investing) and comfort level. Know yourself well and decide accordingly.  It can be passive, active or both.
2. Having said that, the smaller your portfolio, the greater you should think about passive investing. This is where I disagree with Carrick- a 50/50 split between passive and active investing is too aggressive with a small portfolio. With a smaller portfolios, loss and costs are magnified on a relative basis which suggests an emphasis towards passive management.
3. The less knowledgeable you are, the greater you should think about passive investing. Active managing is not about picking the right stock per se. It is about understanding business. If you know little about how business works, have yet to mastered reading a financial statement or have no interest in doing either, passive management may be for you.
4. Passive management can become stupid management in a hurry. Exchange traded funds (ETFs) have become short-hand for passive management and there is some belief, promoted by the financial industry, that all you have to do is pick a bunch of ETFs and you are a successful passive manager of your money. The problem is that the excesses of the mutual fund industry have slipped into the ETF industry- bad product, rising fees, duplication to name a few. Remember the lesson of the institutional investors- passive management is based upon investing in BROAD based indexes and not niches. Do not equate passive management with no thinking management. One is still required to think about asset allocation, reallocation and product purchases to align with the foregoing. The number of decisions one has to make is less but you still have to think.
5. Finally… stick with a strategy. There is no harm in combining a mixed strategy as long (i) see number 1 and; (ii) stick with the strategy (I am going to defer to Carrick about product choices).  The same applies if you are moving from one strategy to another- don’t stop. If you allocate 30% of your portfolio in active management, stick with it. Don’t abandon it at the first sign of trouble and vice versa for passive management. Performance, for either approach, does rely in part on hold periods. Time is your friend in investing so don’t turn your back on your friend.