Now Is No Time to Be ‘Passive’
Being “passive” implies sitting back and, for better or worse, letting fate run its course. Is that any way to handle your finances? By its very nature, virtually doing nothing and letting your account rise and fall with the sways of the market may be one of your greatest risks of all – especially as you get closer to retirement.
Who Is Minding My Money?
The worst risk an investor takes is the one they do not intend to make. With regard to actively managed portfolios, the ability to reduce and/or eliminate many of the risks, that often unknowingly plague passive investors, will come with a price. So, while passive investing can provide full index access at a lower cost, the strategy carries many intrinsic market risks with it. To an investor, the biggest risk - and likely the most unrealized - in piling onto the passive investing bandwagon is that it virtually puts the attainment of investment and retirement goals on “cruise control.”
Consider this: a short-term index fund gain can be eliminated quickly by a short-term loss. If the risk of loss were reduced, thereby preserving your principle and your gain, then does an actively managed fund actually cost more if it can reduce your long-term downside risk?
An old saying goes: “The bitterness of poor quality remains long after low pricing is forgotten.” Investing is no different than anything else -- you get what you pay for. In this respect, an actively managed fund may cost a bit more, but it can do a lot more by focusing on the probability of good outcomes by managing risk instead of the possibility of great outcomes by taking on more risk.
In 2008 when the S&P 500 had a -57% drawdown, an investor with the same loss would have needed a 133% rebound to break even. During that same period, many of our clients were down by 15% and required a much more achievable 18% rebound to regain lost ground.
While index-tracking securities tend to post good returns during extended bull markets, the reverse is also true; in bear markets, passive investors may need to brace themselves for significant losses. In other words: what goes up must come down if nobody is minding the money.
In order to save costs, passive investors generally sacrifice crucial risk management capabilities such as:
- Flexibility – management teams often protect via strategic allocations
- Decision-making – choosing responsible fund management
- In-depth choice – active managers provide options for diversification
Conversely, in an actively managed strategy attributes that act to control investment performance include:
- Duration of positions
- Asset allocations positioning the portfolio to counteract risk
- Security selection based on research
When our future is being considered, we like to have a choice in what we are willing to risk. By investing solely in passive index-tracking securities, an investor cedes the opportunity to manage risk to the whims of the market due to the securities’ limitations. For example, a move in interest rates can make a passive investor unknowingly exposed to a negative market, whereas an astute manager could mitigate this risk by re-allocating portfolio positions as needed. A passive fund can match the market but it will almost never beat it and will carry its inherent risks.
The Allocation Advantage
Active investors can take advantage of temporary moves caused by passive investors forced to comply with the dictates of an index. Alternatively, with passive investing there is no one examining the balance sheets, researching what-if scenarios, and – most of all – considering the impact of major risk factors. During a long-term investment, which is what most passive investing is, these factors will almost certainly come into play. When the seas get rough, the experience and judgment of a manager can make an incredible difference.
One of the most important capabilities of active management is individual security selection. Most active managers regularly seek to identify “mispriced securities,” which they categorize as opportunities, and research ways in which they can position their portfolios for future market and interest rate movements. Managers, like many investors, understand that markets are not completely efficient, setting the stage to seek out and capture opportunities for investors. On the other hand, index funds tend to rebalance on a regular schedule, exposing the fund to price inefficiencies, as well as style and size drift.
Active managers can open and close positions based on their risk assessments, yet passive managers must hold their positions no matter the climate. Similarly, while selling out of a position at a profit may mean a capital gain and a subsequent tax event, advisors are able to manage this by selling losing investments to potentially offset some or all of the taxes generated by winning selections.
The bottom line is that an actively managed fund can be less risky and provide better returns than a passively managed rival on a long-term, risk-adjusted basis. With low turnover – how frequently a fund opens and closes their positions – and competitive fees, the advantages can grow further. Passive investment products tend to shine only when markets are robust but expose investors to virtual free fall in bear markets. Conversely, portfolios with the experience and judgment of a seasoned manager and a team of research professionals can provide careful security selection, timing, and risk management can provide superior long-term risk-adjusted returns.
DISCLAIMER: 1. The views expressed are not necessarily the opinion of Royal Alliance Associates Inc., and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Individual circumstances vary. Investing is subject to risks including loss of principal invested. No strategy can assure a profit against loss.
- There is no guarantee that active asset management will outperform a buy and hold approach to investing.
- Investing in mutual funds involves risk, including the potential loss of principal invested. Risks vary depending upon the strategy used by the fund as well as the sectors in which the fund invests. When redeemed, shares may be worth more or less than the original amount invested.