Active vs Passive Investing: The Age-Old Debate – Part Deux

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Active vs Passive Investing: The Age-Old Debate – Part Deux

In Part One of the Active vs Passive Debate, I discussed how difficult it is for funds to outperform their benchmarks over long time horizons.  However, every decision we make on how we allocate our money within our own investment portfolios is an active decision.  And I think this is where “active” management becomes critical.

What does that mean?  Well, it certainly doesn’t mean to go out and day trade.  Or month-trade.  Or even quarter-trade.  And I’m pretty sure those aren’t real words, by the way.

But, let’s say you have a portfolio of 60% stocks and 40% bonds.  How you divvy up that 60% stocks – US vs international, large companies vs small companies, etc – is an “active” decision.  As is how you divvy up the 40% bonds – government vs corporate, US vs int’l, etc.  So, the idea that passive investors are actually passive is both true and false.  Even the most passive FUND investors have a bias towards active management within their PORTFOLIOS.

Whaaaat?  How can that be?  Even Vanguard themselves, the kings of passive investing, have allocation funds (funds that include stocks, bonds and cash all in one fund) that are grossly skewed towards US stocks.  Some of those funds have US stocks making up 80% of their overall allocation, yet the US only produces a little under 50% of the world’s total economic output.  And the US makes up a little less than 50% of the total market capitalization in the world.  So, in essence, Vanguard is making an active bet on over-allocating toward the US.

Interestingly, if you tally up all of the financial assets in the world, you’d have something that more closely resembles about 45% stocks and real estate and 55% bonds

[1].  So, in theory, any deviation from that split of stocks and bonds would be an “active” decision.

Mind blowing, right?

My personal belief is that if you can use passive FUNDS that track benchmarks that tend to outperform 80-90% of most active FUNDS in most situations, why not use them?  And certainly, opportunity exists in some areas where active funds look a lot more attractive.  But even then it’s hard to know what’ll happen in 5 or 10 years.  Take Dan Fuss at Loomis Sayles for example.  He’s an icon in the bond world.  And his long-term track record is fantastic.  Yet, even he has periods where he struggles.  And as the linked article indicates, investors are pulling money out of his fund because he is lagging the benchmark and his peers.  For those investors pulling their money out, they are locking in losses when the Loomis Sayles bond fund performs poorly, to go chase returns that other funds already banked.  Buying high and selling low…the opposite of what we’re supposed to do.

To wrap up, what I’m suggesting is that there are two levels of active management.  The first comes from the fund level.  In that case, most active funds tend to underperform their benchmarks over long time horizons.  Therefore, it makes sense to use a passive investment or mostly passive approach when selecting individual funds.

The second level of active management is how you allocate those individual passive investment funds (or mostly passive investment funds) in your own portfolio.  Hypothetically speaking, someone who is 70 years old, has enough money to live off of and doesn’t want to see a lot of fluctuation in his portfolio might be better off making an active decision to have maybe 20% or 30% in growth oriented investments like stocks and 70% or 80% in bonds and/or cash.  Conversely, someone who is 45 years old and still accumulating assets and is comfortable with some volatility might be better off with, say, 60% or 70% in growth investments like stocks and the rest in bonds.  It’s an individual choice based on individual circumstances.

Let the “active” decisions in managing your portfolio come where it matters most.  And where it matters most is how much to allocate towards each asset class (stocks, bonds, etc.) in your PORTFOLIO that’ll give you the best chance for financial success.  If you want to pick active funds, choose wisely.  Opportunity exists, but it’s awfully hard to predict the future.

[1] Source:  The Global Multi-Asset Market Portfolio 1959-2012, Ronald Q. Doeswijk, Trevin W. Lam and Laurens Swinkels, January 2014