A discussion about active managers or simple passive investing can quickly turn into a heated debate because investors and wealth managers tend to strongly favor one strategy over the other.
While investing in markets (passive investing) is cheaper and more popular among investors, there are arguments to be made for the benefits of active investing, as well, especially since active managers manage passive allocations (instead of investing in specific stocks they invest in asset classes).
78 -97% of Actively Managed Portfolios Failed to Beat the Index
Active investing, as its name implies, takes a hands-on approach, and requires someone to act in the role of a portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset.
A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change. This strategy is very challenging and the S&P Dow Jones index reports that 78 -97% of actively managed portfolios failed to beat the index they were benchmarked against over ten years. The report claims that the longer the manager is measured the greater the likelihood of them underperforming.
Active investing requires confidence that whoever manages the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.
The Efficient Market Hypothesis (EMH) demonstrates that no active manager can beat the market for long, as their success is only a matter of chance; longer-term, passive management delivers better returns.
Passive Investing – Very Sophisticated and Provides a Larger Toolbox
If you are investing in markets, (passive investing) then the theory is that you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality.
The prime example is simply to invest in an index of equities with a strategy that is defined in the prospectus. This will deliver diversification and exposure to the specific index you want to track.
Today passive investing has become very sophisticated and allows us to access not only markets such as S&P and FTSE but also asset classes such as “electric cars” or “alternative energy”. This provides us with a much larger toolbox when putting together a portfolio and allows us to focus on sectors or geographies that have more growth potential.
The Secret is in the Methodology and not in The Asset.
Academic research over the years from the world’s leading universities has proven that it is much more important to define life goals than to define investment goals. Defining life goals and then matching them with an asset allocation takes into account things that no active, passive, or alternative manager takes into account and that is to deliver the goals aligned with needs for liquidity, capacity for loss, and need for exposure to risk (not only attitude).
Asset Liability Matching
The concept of asset/liability matching focuses on the timing of cash flows and not only returns because professionals must consider and document the payment of liabilities. The process must ensure that assets are available to pay liabilities as they come due and that assets or earnings can be converted into cash as required.
In the case of life planning, the professional must understand all the families’ goals that require immediate resources such as home improvement, education, assisting children, and health issues. And of course the cost of living the life we dream of after we no longer can create income and need to live off the resources we have accumulated.
Of course, the “art” of advising families is not an exact science and it is full of surprises that no one can forecast, and this must be explained.
Financial Planning is a Process, not a Product
I always say that professional “planners” are like medical professionals who study for many years to be proficient in methodologies (protocols) for each and every medical event, but they cannot forecast the future or guarantee results, only that they are educated in the methodology, and the chances of success are significantly better with them than without them.
Financial planning is a process, not a product. It is the long-term method of wisely managing finances to achieve goals and dreams, while at the same time negotiating the financial barriers that inevitably arise in every stage of life. To create a sound financial plan, goals must first be established. Data is then gathered to analyze and evaluate the financial status. Once complete and agreed upon, the plan can be developed and implemented. Monitoring the plan on an ongoing basis is essential to make necessary adjustments to achieve these goals.