Active is Attractive but Passive is Massive
The active versus passive management battle has raged on for decades now. Active managers are constantly seeking alpha (returns above those of the fund's benchmark index) while index fund providers proclaim that such a pursuit is a fool's errand in the long run.
The thought of beating the market is attractive to all of us. Why settle for an average return of 9% if we can have 11% with the same risk exposure? This argument is at the heart of the actively managed portfolio manager's pitch. As one of my old bosses used to say "Fantastic! If it's true."
Yet few actively managed funds consistently beat their benchmark indexes. You may see a nice run here and there but eventually the market catches up to them. This happens in part because there almost always is increased risk exposure required to beat the markets, which means eventually the downside potential of that increased exposure will happen. The law of large numbers is hard to avoid.
Take a look at the latest Standard & Poor’s Indices Versus Active Funds Scorecard. The only asset class category where the majority of actively managed funds beat their index was Large Cap Value funds over the 3 and 5 Year time horizons.
Remember, the active portfolio managers of the funds that are trying to beat the markets are all participating in the same market. Some will outperform the market and some will underperform the market but in the end they will all average out to the market.
Does this mean you should buy the indexes and "set it and forget it"? No, it just means that in most cases actively managed funds are not worth their price premium.
What to do?
What we do at Course Pilot Financial is take an active investment management approach using passive investment products like index funds and ETFs that track specific asset class or sector indicies. I know, it sounds weird to actively manage passive investments but stick with me.
Your financial life is comprised of a set of variables. Some of these variables are controllable and some are not. When it comes to your investments you can control how much money you put in to our investment pool, how you invest that money, when you take the money out and how much you take out. When it comes to the "how you invest your money" variable or "your portfolio" the one true controllable variable is risk exposure.
How much money should you put at risk? What is the expected return on this investment? And what is the downside potential? All of these questions are much easier to answer using passive/index tracking investments.
Why? Because we know how the indicies have behaved in the past and this gives us much more clarity about how they might behave in the future. Does this mean we can predict the future? No, of course not. But we can model likely outcomes given certain asset allocations over time.
History has given us the range of outcomes that are possible from the "irrational exuberance" of the dot com bubble to the great depression and everything in between. These range of outcomes and their interrelationships help us create a framework that we can use to design and manage portfolios that meet your needs without taking unnecessary risks.
Below are a few advantages of this approach:
- Focus is kept on your goals. You are not investing to beat the index, you are investing to achieve your life goals. It is possible to come up short of your goals even if you beat the S&P 500 every year if you fail to manage your other variables properly. It is equally possible to achieve all of your ideal goals while never beating the index.
- Confidence. Using index tracking investments allows us to model with confidence and provide you with an actual measurement of the likelihood of success. Example: 86% chance of exceeding your goals. That's powerful stuff. It helps you sleep at night. We aren't relying on picking the right stocks and hoping we were right.
- Low Cost. Index funds and their ETF counterparts of dramatically less expensive than their actively managed counterparts. Hiring an investment advisor to help you achieve your goals is smart but paying more than you need to for a packaged investment product that will likely underperform a less expensive option is silly.
What do you think? Are you investing in active funds or passive funds? Have I changed your mind? I know I mixed in an example that has a bit of a marketing pitch feel to it but I did so to articulate a point that I believe to be true regardless of whether you hire an advisor (Course Pilot or other) to manage your portfolio.