Synopsis: With passive investing you typically lock in underperformance to the benchmark. Whereas, with active investing you can achieve market outperformance. Understanding the advantages and disadvantages of both strategies allows you to better work with your advisor to develop a sound investment portfolio.
Active or passive? The debate rages on as many intelligent investors feel strongly one way or the other. One of the issues with the active versus passive debate is the tendency to see the issue in black and white. While we at Wolf Group Capital Advisors consider ourselves active investors, we also incorporate some aspects of passive investing into our investment strategy. As with most situations in life, the answer is a bit gray rather than black or white.
In the following paragraphs, we will define active and passive investment management, will talk about some advantages and disadvantages of both styles and will then provide some direction as to how we at Wolf Group Capital Advisors best incorporate both strategies into optimal portfolio construction.
One easy way to understand the definition of passive investing is that it is a strategy that seeks to match the market’s return with low costs and minimal transactions fees. Active investing is a strategy that seeks to outperform the market on a risk adjusted basis. Passive strategies most often use index funds to build a portfolio allocation. The activity in the portfolio is limited to occasional rebalancing to better approximate the index. Active investing, either through mutual fund selection or through individual security selection, relies not only on the portfolio allocation but also security selection in an attempt to outperform the market averages. Here are some advantages and disadvantages of both styles:
Incorporating active and passive strategies into optimal portfolio construction
Because the “average” mutual fund manager cannot beat his benchmark all the time does not mean that active managers do not outperform nor does it mean that one should not consider active investing. Zachary Karabell, Head of Global Strategy at Envestnet, penned in a recent Barron’s article “whether motivated by a need to reduce volatility or add alpha, the use of actively managed funds is a key component to long-term returns. Active managers on average tend to be more risk averse. Incorporating them into a portfolio strategy can potentially lessen market downside, whereas a pure passive approach could leave investors fully exposed in a market drop.” We agree with Karabell’s assessment in that risk mitigation is paramount. Actively managed funds are universally lauded as being inherently better suited to manage risk.
In terms of specific fund selection, when selecting active mutual fund managers for our clients’ portfolios, Wolf Group Capital Advisors tends to lean towards those managers that have high “active share” relative to their peers. Simply put, active share measures how far a fund deviates from its benchmark. This willingness to diverge greatly from one’s benchmark is a hallmark of a manager with strong conviction. We want our fund managers to be willing to “dare to be great” by differing markedly from their benchmark.
Furthermore, we find that there are still many areas of the investing landscape where investing passively does not make sense as the available options leave much to be desired. Moreover, in asset classes where there are more inefficiencies than in other areas, an investor would want an active manager to be able to exploit the discrepancies between an asset’s market price and its intrinsic value.
An area where passive investing makes sense is when an investor wants exposure to a specific area of the market. For example, if one believes that financial stocks are grossly undervalued based on a market overreaction, an ETF that only invests in financial companies would make sense. Alternatively, if an investor just wants to own a certain corner of the market—the 50 smallest companies in the Russell 2000 or the top 30 highest yielding companies in the S&P 500—an ETF offering that exact type of exposure would be reasonable.
From a portfolio management standpoint, the flexible nature with which Wolf Group Capital Advisors manages each individual client portfolio is what many of our clients say differentiates us from our competitors. Our clients tend to greatly appreciate the high level of customization each portfolio receives.
In summary, while we believe active investing provides advantages that passive investing does not, we also believe that there is a place for passive investing in optimal portfolio construction. Our opinion is that the ideal approach entails using active management while prudently incorporating some facets of passive management to gain cheap exposure to specific areas of the market. Wolf Group Capital Advisors has assisted hundreds of clients with developing customized portfolios based on our clients’ needs. Contact us now at (703) 502-9500 to schedule a meeting with one of our advisors.
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Opinions expressed herein are subject to change without notice. Wolf Group Capital Advisors, or one or more of its officers or employees, may have a position in the securities discussed herein, and may purchase or sell such securities from time to time.
Additional information, including management fees and expenses, is provided on Wolf Group Capital Advisors’ Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Past performance is not a guarantee of future results.
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