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Ignore the siren song of passive management

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Investment managers these days come in all shapes and forms: active mutual fund managers, steeply priced hedge fund managers, robo investment advisors, passive exchange-traded funds, just to name a few.

Over the past few years, the industry has gravitated toward low-cost index funds as the primary component of investment allocations. Although these funds have merit within portfolios, they are certainly not a one-stop solution.

Passive investments, such as cheap index equity ETFs, provide investors with an effective way to gain exposure to market capitalization-weighted indices such as the S&P 500, which sensibly can serve as an anchor of a diversified investment allocation. However, there is a fallacy in investors assuming that this in and of itself is the most suitable method to invest their entire asset base.

Consider the following:

  • By investing in these funds, investors are fully accepting underperforming the benchmark over every timeframe, by a margin of the nominal investment management fee.
  • Investors do not have the ability to participate in thematic market changes that present opportunities over various market cycles.
  • Investors do not have any protection against market downturns; they are passively accepting the risk inherent within the benchmark.
  • There is no ability to take advantage of market dislocations created by exacerbated volatility.
    To build a better portfolio, it is crucial to maintain a degree of active management. In fact, I always ensure that within inefficient areas of the market I maintain some active exposure over a purely passive approach.

That said, all active managers are not created equally. This is perhaps why many investors have shunned this style of management, as it requires a hefty level of due diligence and effort.

When we engage active management, we agree, in essence, to pay a premium for risk-adjusted returns that, net of fees, exceed that of index funds and ETFs. Therefore, it is important to understand whether their portfolio management warrants the fees levied upon investors.

Too often, active managers hide behind the safety of the benchmark and fail to materially distinguish their portfolios.

Although passive management has been crowned the king of the past few years, fueled by egregiously inflated monetary policy, it looks as if there could soon be a changing of the guard. The election of President Donald Trump certainly may be looked back upon as the catalyst for such a change.

Changes in fiscal policy and resulting economic growth will increase return dispersion across equity sectors. Volatility will undoubtedly rise around looming uncertainty in Washington; investment managers must encompass flexibility to navigate an unpredictable market environment.

The rising tide that lifts all boats, created by historically loose monetary policy, has come to shore, and it will be increasingly difficult to deliver suitable returns in equities by simply accepting what the market offers. In other words, the romantic affair between investors and passive investing may have been trumped.

This story is part of a 30-30 series on building a better portfolio.

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