Defined: Active versus Passive Investing

December 15, 2018

It’s been a challenging few months in the domestic securities markets, it’s been worse abroad. We can all debate about the genesis of this turmoil, but that’s not the intent of this commentary. Instead, it’s times like these that I would like to take the opportunity to define and address the main differences between two different approaches to asset management. I also intend to describe why there continue to be confusion around these different ways of providing investment services.

Passive investing is a term generally used to describe long-term, buy and hold positioning whereby the intent is to maintain a set asset allocation (stock to bond mix) that is appropriate for your risk tolerance. This allocation is to be maintained until
there is an observable difference in a person’s risk tolerance. Additionally, you would generally rebalance the portfolio back to the original target allocation and this rebalancing typically happens annually, but not necessarily.

In recent years (think the last 10-15 years), passive investing has become synonymous with “indexing”. However, indexing more appropriately describes a distinct vehicle in which to invest passively by replicating the investment experience of a benchmark, i.e. the S & P 500. Indexing certainly is a very low cost manner in which to invest, but it is not the only passive option. For instance, you could invest passively in a portfolio of individual stocks, mutual funds, index funds, etc…

The term “active” in the context of investment management has become a taboo term in some sense so we’ll spend more of our time talking about this type of investing. Here then, let’s start by delineating between the process of incorporating active investment management into a portfolio at the allocation level versus active management at the fund level. The distinction is important.

In my opinion, the bugaboo around active management stems from a value proposition issue at the fund level, i.e. actively managed mutual funds. It is in that regard that the realm of active management has come to be viewed with some degree of negative connotation. Essentially, these kinds of funds have higher cost burdens and this has, in part, led to underperformance compared with respective benchmarks. However, there is a different type of active management that deserves some additional attention.

At Allied, our investment philosophy stems from what we believe is the evolution of asset management. It was once, in our opinion, sufficient to invest in a broadly diversified asset allocation and be patient. Unfortunately, with advent of a
24 hour news cycle; Twitter, Facebook and the speed with which information moves from one part of the globe to the next, the entire world has access to investment data within fractions of seconds from when events take place. Within that framework we see split second investment decisions being made without, perhaps, the level of foregoing consideration that once would have been commonplace. It is within that world that we believe active management of a different kind plays an integral role in our clients’ financial stability.

Active management within this context simply means paying attention to the changing economic conditions to intelligently take notice of what could be large shifts in sentiment or other broad trends that ultimately may lead to a different investment paradigm. Once observed, the intent is to shift the allocation in a way to take advantage of that changing environment. This may mean overweighting or limiting exposure to certain asset classes at different times in an economic cycle. The resulting experience then is intended to reduce overall volatility and create a more consistent long-term rate of return.

We strongly believe that incorporating EACH type of investment management into your portfolio provides the greatest opportunity to participate in a more stabilized short AND long-term investment experience. Let’s plan for the best by incorporating
long-term, low-cost and passive investment strategies. But let’s acknowledge the realities of our markets by also incorporating strategies that can approach the market pro-actively and with an eye to risk mitigation.

Many of our clients have taken advantage of these opportunities over the years and continue to benefit from these meaningfully different; yet complimentary strategies, in order to smooth out and provide a more palatable investment experience.

We have written recently about the risks we perceive in the markets today. If you missed our e-mail in October on that topic, please let us know and we will ensure you’re able to obtain a copy of this article.

As we approach what could be the final chapter of our most recent bull market (which started in March of 2009) I’d like to take notice of the fact that only few times in history have we experienced such a robust market for so long. This should not in and of itself usher in its demise, but it would be worth reviewing your investment approach to ensure you are comfortable with either its flexibility or its limitations in its ability to adapt to changing market conditions. If you would like to have a conversation around these items, we look forward to helping you explore your options in a clear and thoughtful manner.


by David A. Younis, CFP ®, Director of Financial Services