Why passive asset managers represent high risk for financial advisers

Passive third-party asset managers could expose clients to a greater level of risk and dissatisfaction.

Recently, I spoke with a financial adviser who is increasingly worried that a client complaint could make its way onto his record. A large number of clients have called him, wondering why their portfolios trailed the broader market during the post-election surge and throughout the bull market since.

The reason? Nearly all of these clients are broadly diversified in low-cost, passive funds.

Sure, passive strategies tend to be cheaper, require less time to execute and represent a patient approach. They recognize that investing for the future is a marathon, not a sprint.

(More: How to pick the right active manager)

Unfortunately, passive third-party asset managers could potentially cause advisers to expose their clients to a greater level of risk and dissatisfaction — especially during the next extended market downturn.

Here are the top three reasons why financial advisers should beware of over-emphasizing passive asset managers with clients:

1. Little downside protection can stoke negative emotions. A buy-and-hold strategy requires investors to take the good with the bad. At first glance this sounds fine, since all clients have to do is stay patient and watch their money grow over the long term.

But retail investors frequently don’t do that. Investing is a roller coaster ride, and even the most prudent retail investors will make the wrong decision at precisely the wrong time — whether it’s getting out during times of peak unrest or riding things out until they recoup their losses, and then exiting.

2. Failure to account for how markets historically behave. Studies going back more than 100 years — including ones conducted by Ned Davis and Associates, UBS Global Asset Management and Callan & Associates — all show that equity markets move asymmetrically. They decline about 40% of the time, recover from those declines another 35% of the time and reach new highs only 25% of the time.

While nearly everyone knows markets don’t move on a linear basis, very few realize how frequently they are either declining or recovering from declines. With new highs few and far between, the average investor very often feels like their portfolios are going nowhere, and this lack of perspective on historical market trajectories can tempt retail investors to make the wrong decisions when they are all in with passive strategies during a prolonged market downturn.

3. Retail investors are easily discouraged. On the other side of the market performance equation is how the typical investor is easily disappointed when they don’t see gains pile up consistently, and move precipitously to take their chips completely off the table.

Active management, by contrast, promotes more engagement with and commitment to the investment process, empowering clients and giving them the sense that they are exerting some level of control over the market versus having the market always control them. When there’s distress, active managers can pinpoint areas where risk is elevated and make calculated, incremental asset allocation adjustments that have the potential to limit the damage. Similarly, when markets are more buoyant, there will be opportunities to maximize gains.

(More: How to deploy cash in this market)

So what’s the answer? Certainly, half the battle is carefully selecting active asset managers that have a clearly defined, deliberate and disciplined approach to risk management — recognizing that there have been a number of active managers that have given this segment of the investing industry a bad name.

Beyond this, it is incumbent on the financial adviser to start each client engagement by developing a comprehensive financial plan with clearly delineated goals that all asset manager selections can support.

This approach will not only help rein in the retail investor from self-destructive emotional tendencies, but also creates a solid framework for the financial adviser to best help their clients reach their vision of how to enjoy a life well-lived.

Greg Luken is founder and CEO of Luken Investment Analytics, a third-party quantitative research and asset management firm.