Why the best portfolios mix active and passive investments

Beating a benchmark is an empty victory if an investor cannot meet their financial priorities.

“The reports of my death are greatly exaggerated.”

The famous quip attributed to Mark Twain humorously captures a theme that many financial advisers and investment managers would apply to active management. In my experience as an adviser, the best portfolios meet each client’s individual needs with a mix of both active and passive investments. The popularity of low-cost passive strategies has garnered significant press, yet claims that active management does not work or is dead would be gravely mistaken.

Passive index strategies are typically marketed as low-cost, diversified approaches providing market or sector exposure and approximating benchmark performance. According to Morningstar, assets under management in passive mutual funds exploded 320% globally to $6 trillion since 2007, whereas actively managed funds grew 54% over the same time. The well-documented underperformance of the average active investment manager has added to the popularity of low-cost index alternatives.

The rise and fall of investment fads — Nifty Fifty, BRIC, etc. — begs the question of whether the herd mentality of passive-only won’t suffer a similar fate. If everyone is doing it, is it the best strategy, or a crowded trade that typically delivers average outcomes? Time will tell, but this theory rests on premises that deserve a second look.

INVESTOR GOALS

Many studies break down numbers and analyze data in active and passive strategies. However, the important step of asking investors if beating the index is actually their goal is typically overlooked.

Advisers know their clients should be focused on defining goals unique to their situations as they have individual preferences, dreams, etc. and, most investors do not fit comfortably in an index box. Translating these objectives into a cohesive plan results in a personal index, which may or may not have any relation to benchmark performance. Will I have sufficient health insurance coverage during retirement? Can we still travel? Objectives like these are often the most important targets for investors. While one goal might best be served by a passive-heavy strategy, another might benefit from a more active approach. Beating a benchmark is an empty victory if an investor cannot meet their financial priorities.

TIME & THE DOWNSIDE

Another element misinterpreted in most studies is the actual investment time horizon. Studies typically examine relatively short intervals (i.e., up to 5 years) for comparisons rather than the 20- and 30-plus-year horizons of most investors. Looking at longer time spans can reveal sharply different conclusions. A study from The Capital Group, examining investment results from 1934 through 2015, revealed that their actively managed funds outperformed their respective indexes 85% on a 20-year basis and 96% on a 30-year basis.

Whereas volatility can be an investor’s friend in the accumulation phase of life, it can be an enemy during distribution years, particularly in a down market. Actively managed funds, which provide lower downside, capture can give both peace of mind and help retirement funds last longer.

IDENTIFYING OUTPERFORMERS

Most studies conclude that the average active manager does not beat their benchmark, but these studies typically neglect to ask whether it is possible to identify managers with a consistent record of beating their benchmarks. After all, why would an investor choose to be average if a better approach were readily attainable?

Morningstar’s Fantastic 50 screen in 2015 put nearly 8,000 mutual funds through rigorous filters to identify a subset of fund candidates with outperformance over their manager’s tenure, superimposing a minimum tenure of five years or more. These funds outperformed their benchmarks, net of fees. The key differentiators? Low costs, significant manager ownership and low volatility. Capital Group independently confirmed using Morningstar data that low expenses and high manager ownership “significantly improved success rates” and were associated with stronger returns.

Some might argue that passive indexing is another example of a disruptive technology changing investing. While passive strategies certainly may have their place, the most strategic portfolios best serve an investor’s goals through a combination of active and passive.

Investors are not average, but rather individuals with unique preferences, worries and dreams. Expert counsel that translates these attributes into a well-crafted plan, tracked over time, can better ensure positive outcomes.

Andrew Crowell is vice chairman of the individual investor group at D.A. Davidson & Co.