Executive summary:
- The debate over whether active or passive strategies are superior has persisted for decades
- Both hold significant benefits for an investor; there is a growing argument that both deserve a place in a diversified portfolio
- Combining passive and active strategies in a portfolio can offer benefits not provided by either alone
In the ever-evolving investment landscape, one thing has persisted for decades: the debate about the superiority of active or passive strategies. While many pundits strongly advocate for one approach over the other, there are now valid arguments that a combination of both active and passive strategies offer portfolio benefits not provided by either alone. In this blog, we will highlight the advantages of integrating these two strategies and explore how financial advisors can harness the benefits to better serve their clients' investment needs.
Understanding active and passive investing
Before reviewing the benefits of combining active and passive investing, let's define each strategy:
- Active investing: Actively buying and selling securities, attempting to outperform the market or an assigned benchmark. Active managers rely on research, analysis, and their judgment to make investment decisions. While potentially offering higher returns, active investing also comes at higher costs and risks.
- Passive investing: Passive investing attempts to match the performance of a specific market index or benchmark. Instead of attempting to beat the market, passive investors seek to match its returns. Passive exposures typically are acquired through low-cost mutual funds or Exchange-Traded Funds (ETFs).
The case for active management
Active management offers several compelling benefits that appeal to advisors and investors seeking returns above the market average. Skilled active managers take advantage of market inefficiencies, exploit mispriced securities, and adjust portfolios in response to changing market conditions. This flexibility allows active managers to potentially generate above-market returns, particularly in volatile or inefficient market stretches.
Active management provides advisors with the opportunity to align their client portfolios with specific investment objectives, risk tolerances, and other preferences. By actively selecting individual securities or sectors, active managers can tailor their portfolios to reflect specific goals or values desired by investors.
Furthermore, active management enables investors to take advantage of specialized strategies and asset classes that may not be well represented by passive vehicles. Real assets, such as infrastructure and real estate, and return-seeking bonds, such as global high yield and emerging markets debt, are examples of asset segments that have less than ideal index coverage. Active management expertise can effectively navigate and capitalize on the unique opportunities within these markets to hopefully add additional returns.
The appeal of passive investing
Passive investing has gained popularity in recent years due to its simplicity and cost-effectiveness. By tracking market indices, passive funds offer broad diversification across various asset classes at a fraction of the price of active strategies, providing overall lower-cost solutions.
Another advantage of passive investing is its consistency. Since passive funds aim to replicate market performance, investors can expect more predictable returns and reduced portfolio turnover compared to active strategies. This predictability can be particularly beneficial for advisors working with investors who are tempted to chase strong active performers. Removing this temptation allows clients to benefit from the stability of lower turnover.
Finally, passive investing aligns well with the principles of efficient market theory, which states that asset prices reflect all available information and are therefore difficult to consistently outperform. By accepting market returns rather than attempting to beat the market, advisors and clients can focus on activities within their control, such as asset allocation, rebalancing, and cost management.
The benefits of both strategies working together
While active and passive investing represent distinct approaches, combining these strategies can create a powerful solution that leverages the strengths of each. By integrating active and passive strategies within a multi-asset portfolio, advisors can construct well-diversified, cost-effective investment solutions tailored to their clients' goals, preferences, and circumstances.
One approach to combining active and passive strategies is through a core-satellite construct. In this model, a diversified core portfolio consisting of low-cost index funds serves as the foundation, providing broad market exposure and stability. Surrounding the core are satellite positions managed actively by skilled fund managers, aiming to add excess returns and enhance overall portfolio performance.
Another approach is to establish the solution's strategic asset allocation, and then implementing it from the bottom up, identifying and allocating to those segments best served by active and those best served by passive management. The active allocations tend to lean towards the market segments that are less efficient, offer a higher risk/return trade-off, or have poor passive coverage. Passive allocations can round out the portfolio by offering inexpensive, broad market diversification in asset segments that possess higher hurdles for excess returns.
These are just two possibilities, and advisors need not limit themselves to these approaches. This is just scratching the surface of the many ways that advisors can construct diversified portfolios capturing the benefits of both active and passive strategies.
Summary
The debate between active and passive investing need not be an "either / or" choice for financial advisors and their clients. By recognizing the unique advantages of each approach and integrating them strategically, advisors can construct well-balanced portfolios that offer the potential for higher returns, lower costs, and reduced volatility.
Ultimately, by harnessing the complementary strengths of both approaches, financial advisors may be able to better serve their clients and help them achieve their long-term financial goals.
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