Understanding Active vs. Passive Investing: Why Should You Care?

There are many ways to manage money, but in general, investment management falls into two primary categories – passive management and active management. Passive management typically follows the tenants of Traditional Asset Allocation whereby you allocate a certain percentage to equities, bonds, cash and other asset classes, and stay invested in these asset classes regardless of market environment – that is during bull markets and bear markets.

On the other hand, active investment management typically applies – as the name suggests – an active approach to managing one’s positions. Rather than “buy and hold” investments, one “buys and sells” based on market conditions. For example, if the stock market is trending up, positions are bought or increased; if the stock market is trending down, positions are reduced or completely eliminated.

So which approach is better?

The answer to this question, like so many aspects of the markets, is “it depends:”

  • Are we in a bull market? If you assess performance during a bull market, then passive management tends to outperform active management. There are many reasons for this, which are outside of the scope of this blog – but in short, it often is very difficult to outperform the S&P 500 Index during a strong bull market.
  • Are we in a bear market? If you assess performance during a bear market, then active management tends to outperform due to the fact that the money manager has reduced or eliminated positions to the particular market that is trending down, be-it US equities, international equities, gold, energy, bonds, etc.

Another important question is:

  • What's your time frame?  To get an idea of the  potential efficacy of any investment approach, you need time.  Many tend to view a  "full market cycle" as a fair time-frame.  A full market cycle includes a bull market and a bear market. According to Tobias Carlisle's* analysis, the average bull market is 67 months (approximately 5.5 years) and the average bear market is 43 months (approximately 3.3 years). If you assess performance over  a full market cycle, then active management tends to outperform given the money-manager’s focus on managing risk – that is, mitigating losses during the bear market.

Of course, both active and passive management approaches can have many shades of gray - so one needs to take into account the investment manager’s specific approach and to recognize that there are no absolutes and no guarantees in this business. However, if you are taking a long-term view, it may be it's worth considering working with an advisor that has a focus on risk management - particularly as you approach retirement, where you don't have the the time to "discover" whether the investment manager's approach is going to support or detract from helping you reach your goals.

As our clients know, we are active money managers. Much of this is informed by my experience in institutional money management, having worked for nearly a decade in on Wall Street, in Connecticut and London primarily for active money managers.

Personally, I believe one of the most important components to building wealth is to manage risk – to strive to mitigate losses.  Managing losses means that you seek to preserve your capital – which means that, over time, you will likely have the ability to compound your money. Compounding just means "making money on your money,” and is an important component of building wealth.  If you lose 50% of your assets during a big bear market, you obviously can’t compound on the 50% you lost!

In addition to the potential for compounding, another possible benefit of active investing is that the approach tends to be very disciplined and quantitatively driven –using price trend data and computer-driven models to help guide when to buy and when to sell. Applying this kind of discipline, often takes some of the stress out the equation – for both the money manager and the client. The client knows that during bear markets, their investment advisor has a discipline – has rules – regarding reducing their exposure to the markets that are in free-fall.

Below is an example of one of the models I use for managing client assets. The analysis illustrates the growth of $10,000 by “buying and holding” the S&P 500 Index Exchange Traded Fund (ETF) versus taking a active, modeled approach.  Investing in the S&P 500 Index ETF by itself, an initial investment of $10,000 jumps to an impressive $287,473 (blue line); but the modeled** approach, where I switch to Treasury Bills (or similar) on model sell signals, takes one up to a hypothetical $2,046,954 (black line). (Please note, I do not  currently employ a Long/Short*** approach, which is illustrated by the red line.)

Active vs. Passive Investing Illustration - Growth of $10,000

A couple of points to note:

  1. This example illustrates the potential benefit of active management over several bull and bear market cycles.
  2. The analysis does not include trading costs or tax implications. However, personally, I would rather pay taxes on $2,046,954 compared to $287,473.

From my perspective, the analysis suggests that active investment management - striving to manage losses, no matter what the asset class****  – may have real potential to beat passive index investing, over time.  I frequently tell my clients that this is why they pay me – to seek to be a good risk manager.  As mentioned, unless you are a very good stock picker (which I try to be in my two stock portfolios), it is tough to beat the S&P 500 Index during a bull market. But during significant market declines, I believe having a disciplined approach in an effort to avoid significant wealth destruction may be worth considering.

Want to learn more?  Join the conversation.

Be well,

Roberta

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Notes:

* Tobias Carlisle is the founder of Greenbackd, a blog dedicated to deep value, contrarian investing. A contrarian, deep value investment approach strives to "buy when other investors are selling, and sell when other investors are buying," with the objective of buying when investments are inexpensive, and selling them when they become expensive relative to historical norms.

** A "model" typically refers to in investment methodology that uses computer systems to help indicate when to buy and when to sell specific securities.  Models are built with the goal of optimizing the risk-versus-reward (loss-versus-gain potential) of an investor's portfolio. Models may include security price data sets, fundamental data sets ( Price-to-Earnings ratio, Federal Reserve interest rate stance, etc.), or a combination of the two. One potential benefit of using a model is that it can be back-tested to see how the model would have performed in the past. While results can never be guaranteed, applying such an approach seeks to increase confidence in one's investment strategy, and again, optimize the risk-versus-reward in one's portfolio.

*** When an investor goes "long" on an investment, it means that he/she has bought a stock believing its price will rise in the future. Conversely, when an investor goes "short" he/she is anticipating a decrease in share price.  "Short selling" is the selling of a stock that the seller doesn't own, which can be a risky proposition.  There are, however ETFs that "sell short" inside of the ETF, limiting one's risk to his/her initial investment, and allowing him/her to strive to profit from a decline in price.

***** Would you really have wanted to be a "buy and hold" investor of energy stocks over these past couple of years? On 9/6/13, crude oil prices peaked at $110.53 per barrel; crude opened today at $45.47 per barrel, a decline of nearly 59%, with many energy stocks following suit.

 

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