David Robinson, CFP

There is perhaps no controversy in the investing world more contentious than active versus passive equity investment management — whether it’s better to have an equity portfolio that’s actively managed or one that passively gets the returns of market indexes or selected groups of stocks. The intensity of this long-running fight is on a level comparable to that of Democrats versus Republicans.

Members of both camps perennially argue that their way is unequivocally the best, despite real-world results that support one side’s argument one year and the other’s the next. As investors seem to have one religion or the other, few use both methods. Yet, when used in tandem, the two methods can work together in ways that deliver the best of both worlds while compensating for the downsides of each. 

Active management — buying and selling individual stocks rather than holding index funds or exchange-traded funds (ETFs) — has some distinct advantages, including:

The ability to apply quality standards when selecting investments to achieve desired levels of liquidity, leverage, profitability and return on equity.

Control over avoiding portfolio concentrations. To some degree, risk can be managed by limiting exposure to certain sectors, industries or companies.

Tax efficiency. Active management of stocks held in taxable accounts (as opposed to those in 401(k) plans and individual retirement accounts) enables the harvesting of capital losses for tax deductions that offset capital gains.

Yet active investing has some distinct disadvantages. Among these is company-specific risk. Because active portfolios necessarily involve far fewer stocks than passive, a decline in one stock has a proportionately greater negative effect than in a passive fund. Another disadvantage is far higher expenses because of trading costs and, if you hire a professional to manage your portfolio or own an actively managed mutual fund, management fees.

By contrast, expenses of ETFs are comparatively low. Yet passive investments have distinct disadvantages, including:

The potential for unintended concentrations in some sectors, particularly during times of irrational exuberance and inflated valuations. For example, the rush to invest in tech firms in the 1990s, leading to a market bubble, involved high concentrations of technology companies in large-cap indexes. Thus, shares purchased in passive large-cap funds conferred disproportionate ownership in these overvalued firms, exposing investors to significant risk.

Performance limitations. Passive funds are built to track indexes or groups of stocks rather than to outperform them. So the index itself will always be underperformed by the amount of the expenses of the fund, however low.

Overall market risk. As many passive stock funds track a specific index or market, when that declines, so will shares.

Of course, active management isn’t for everyone. You must either pay the expenses of mutual funds, hire a personal portfolio manager or make decisions to buy and sell stocks yourself. All of these options, especially the latter, mean you have to keep up with markets, sectors and companies; know how to read a balance sheet; and possess the skills needed to evaluate management teams, companies’ market positions and the durability of their investable propositions.

If you’re comfortable evaluating companies, this can empower an active/passive equity strategy that centers on using active equity investments in companies that are knowable — those you can reasonably expect to obtain information about — and passive ones to invest in those you can’t.

To use this dual strategy, consider starting by establishing your active portfolio in a non-tax-deferred account populated by domestic stocks. One key to selecting individual stocks correctly is to limit the universe you’re actually going to consider. Even when vetting domestic stocks, there are too many for most people to deal with when looking at small-, mid- and large-caps. So it’s best to limit this active section of your portfolio to large-cap (market capitalizations of more than $5 billion) and mid-cap (market caps of $1 billion to $5 billion) stocks.

Small-caps are not only far more numerous, but also difficult to learn much about because they’re generally not followed as closely as large companies. According to this strategy, then, investors’ research time is spent efficiently by evaluating the balance sheets and management teams of large and midsize U.S. companies in 10 or so sectors. 

Yet, this portfolio would be insufficiently diversified. So you add diversity by buying some small-cap domestic ETFs with performance histories uncorrelated with those of your large- and mid-caps, which limits downside volatility. This way, you use passive management’s strength to reduce risks posed by your larger holdings.

Similarly, you can then add global diversity through the purchase of ETFs or index funds that track international or emerging-market companies, whose dynamics are difficult for even most professional American investors to get a good feel for. What’s more, many emerging-market stocks involve significant company risk and, depending on their environments, political risk.

Such a portfolio can productively harness active and passive management’s advantages while using each to reduce risks posed by the other. This type of dual equity portfolio can work nicely with other types of investments — including bonds, real estate and commodities — to produce an overall investment portfolio that positions investors for good total returns with superior downside protection.

David Robinson, a Certified Financial Planner, is founder/CEO of 

, an SEC-registered firm in Phoenix that provides fiduciary services to help clients achieve their financial goals. His practice focuses on helping wealthy individuals with custom financial plans, using a holistic approach to grow/protect wealth, manage taxes, identify insurance solutions, prepare for retirement and manage estate plans.

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When used in tandem, the two methods can work together in ways that deliver the best of both worlds while compensating for the downsides of each.   

Active and Passive Management Working in Harmony

We are now witnessing the beginning of the end of the Chinese economy—and of US-China trade&mdash;as we know them. Developments leading up to this have been under way for years, but the shift is now being catalyzed by geopolitical tensions stemming from the coronavirus 2019 (COVID-19) pandemic.

The shift will ultimately have a transformational impact on American investment markets, some American companies and various investment funds. Investors who get their arms around the situation sooner rather than later and assess potential impacts on their portfolios will be better able to limit damage and position to benefit.

Signs of the shift have been evident for years. China became the planet’s second-largest economy (though one with 

 before the pandemic), from decades of cash infusions from large American companies seeking a cheap place to manufacture. But the Chinese communist government has long flouted the corporate partnerships it approved by setting up competitive entities and committing flagrant patent infringement, much to the bipartisan displeasure of the US government and the dismay of the US companies financially damaged. And in recent years, costs of manufacturing in China have risen considerably. Now, the virus’ impact is awakening American companies with manufacturing operations in China to the need to site plants friendlier places.

Also, noted J. Kyle Bass, founder and CEO of Hayman Capital Management, a Dallas-based hedge fund—and a widely-quoted expert on China’s financial impact&mdash;the shrinking Chinese economy has become highly leveraged and hence, unstable. Among other experts, 

Bass has focused renewed attention on the long-overlooked situation

 wherein the U.S. and other leading Western democratic nations have relied—exclusively in some markets, such as blood-pressure medication&mdash;on the supply chains in a communist nation with an appalling record of human rights violations.

Because of the Chinese government’s actions as the virus spread—issuing propaganda and refusing to cooperate with the West--there’s growing support for Western nations to seek reparations. “There’s a tide of resentment toward China over the virus in the West, including the US, Canada, Australia and the UK,” said Bass. But this would likely result in a stalemate, considering the various implausible counter-narratives on the virus’ origins that the Chinese government is pushing. 

In recent years, U.S.-Chinese tensions have run high over various other factors, including the ongoing trade war and China’s 

 that the entire South China Sea belonged to it—and its construction of islands there, presumably for strategic military purposes.

Regarding multinational manufacturing in China, the virus has accelerated what’s becoming known as the great decoupling of the 2 nations. “As bad as the tech war between the U.S. and China [already] had the potential to become, there was worse yet to go as this split spilled into other economic areas,” says Ian 

. “Coronavirus has sped up that timeline considerably; manufacturing and services sectors have already been forced to begin reorganizing supply chains and staff.”

US-Chinese financial friction is at the highest point in decades. This scenario, heighted by issues over the pandemic, involves these developments:

, seeking to curtail its autonomy and ultimately take control of the city-state. These moves, met by protests in the streets in Hong Kong, are ratcheting up tensions with US because of American interests in sustaining the island as a democratic state.

The Senate’s approval, in late May, of sweeping Trump- administration-backed 

 156 Chinese companies now listed on US exchanges, and from other means of raising money from American investors, if they don’t comply with rules including those requiring them to submit 

to required audits conducted by the Public Company Accounting Oversight Board,

 the nonprofit entity that oversees audits of all US public companies. 

Sen. Lindsey Graham’s proposing legislation, in late May, that would allow President Trump to impose sanctions on China if it doesn’t transparently investigate the origins of the pandemic.

 to shift production from China to Southeast Asia—Vietnam and potentially Thailand. Until now, most, if not all, Google smartphones and Microsoft computers have been made in China. Also, reports surfaced in May concerning 

 plans to potentially move manufacturing from China to India.

Generally, with these developments in mind, investors should take a hard look at their portfolios and consider potential impacts. Specifically, investors should:

Assess the degree of China and China-related exposure in their overall portfolios.

Determine whether they directly or indirectly own shares of any of the 

 targeted in the Senate bill, and assess the potential risks from 

—for companies that fail to comply with the legislation’s requirements (assuming it passes the House).

a likely end to Chinese companies’ advantages from their longstanding status as emerging market companies

. An end to emerging status would mean that these companies would basically have to compete on a level playing field for investment dollars, which could lower asset values and have a major impact on international funds.

Evaluate the ultimate impact that the developing China supply chain rerouting will have on U.S.-based multinational companies, particularly those in tech, pharma and precious metals. Within these sectors, what companies are best or worst positioned to shift supply chains? And with what degree of business interruption?

Assess the investment potential of the indirect benefits of the trade shift for Southeast Asia (Vietnam and Thailand) and the Indian subcontinent (India and Bangladesh). Might this lift investments in these emerging markets?

If US-China relations were to suddenly warm up, the trade war were to end, the 2 nations were to bury the coronavirus hatchet and American multinational companies regained confidence in siting plants in China, this would be nothing short of a miracle. It seems only logical to consider investing in the other direction.

David Robinson, a Certified Financial Planner, is founder/CEO of 

The views expressed in this piece reflect those of the author, not necessarily those of the publication.

The shift will ultimately have a transformational impact on American investment markets, some American companies and various investment funds.

Assessing Investing Impacts of the Great Decoupling

The stock market collapse in March was triggered by a rare phenomenon known in the financial industry as a black swan event.

Black swans are sudden, completely unpredictable events that roil financial markets, catching investors flatfooted. Typically, some with the benefit of 20-20 hindsight say they saw these events coming, but they didn’t. By definition, no one ever does.  

If you could see a black swan event coming far enough in advance, you’d have some time to make protective adjustments in your investment portfolio. But because you can’t, the only thing you can do is be prepared for them all the time because, when they hit, the stock market can fall so precipitously that it’s virtually impossible for individual investors to sell without  significant losses.

How do you get and stay prepared for a black swan event? By constructing and maintaining your portfolio to withstand one without sustaining damage, and by making provisions for how you’ll get by if things get especially bad. Even if you prepare well, a black swan can still hurt you badly. The idea is to limit losses.

As surviving a black swan could be likened to staying safe aboard a sinking ship, the best way to prepare for one is to run a lifeboat drill. Just as an actual lifeboat drill assures that you can get to safety when the ship is going down, a financial lifeboat drill—an evaluation of your readiness&mdash;can help prepare you for when a black swan strikes.  

Do I have enough cash—in accessible accounts, such as money markets&mdash;to pay living expenses for a year? 

Is my stock portfolio focused on high-quality companies that pay reliable dividends? 

Am I sufficiently diversified by asset class?

This exercise consists of asking yourself a series of questions and taking action if the answers don’t bode well for your potential outcome. These questions should include:

Many experts advise having an emergency fund sufficient to last for six months—but that’s more of a peace-time reserve. A black swan event, as the nation is now painfully learning, can be more like war, so doubling that figure is a good move.

Income from dividends can help you get by while you wait for asset values to come back and keep you from having to sell low.

In a steep market drop, some sectors take much bigger hits than other. In a recession, discretionary spending falls sharply, dealing a blow to the stock category known as consumer discretionary—goods and services that consumers don’t have to have and don’t buy as much of in a down economy. The leisure travel and hospitality industries, dealt strong blows by the virus, fall into the discretionary category. As these industries tend to be cyclical, it’s never a good idea anyway to have too much of your portfolio allocated to them. Instead, you want broad diversification to minimize exposure to any one sector.

Considering my time horizon and risk tolerance, does my asset allocation make sense? This means having a portfolio that isn’t too heavily weighted in stocks for what’s known as your time horizon—your anticipated time until retirement. Bonds aren’t consistently correlated with&mdash;that is, they don’t always rise and fall with&mdash;stocks. That’s why, as investors get older, many tend to have more of their money in bonds and less in stocks.

How much of my portfolio should be in bonds? 

If you have an asset allocation of 60% and 40% in stocks, and a black swan event cuts stock values by 35%, as the current black swan did to the Dow Jones Industrial Average initially in March, you’d lose about 21% your total asset value. This isn’t a rosy prospect, but it’s far preferable to losing 35% percent of your asset value from having 100% your portfolio in stocks when a black swan hits, as the recent one did.

Bonds have been paying historically low yields in recent years, and current rates are extremely now. A good option for many investors in such times is to build what’s known as a bond ladder, using short-term bonds. This involves purchasing bonds with overlapping maturities of one to five years, and holding each to maturity before replacing it with another as you go along. This laddered approach generates gradual, reliable income while protecting you from declining values and the inflation that can whittle away at yields. Asset class diversification can also involve the addition of alternative assets such as real estate investment trusts (REITs), which have a low correlation with the stock market.

It’s never too soon to prepare for the next black swan. If you take the right precautions, you’ll be far less likely to see your portfolio go down with a Titanic market and more likely to survive the event from the relative safety of a dry financial lifeboat.  

If you could see a black swan event coming far enough in advance, you’d have some time to make protective adjustments in your investment portfolio.

Prepare for the Next Black Swan with a Lifeboat Drill 

In the greatest wealth transfer in world history, American millennials and Gen-Xers will collectively inherit from their baby boomer parents up to $68 trillion over the next 25 years.

Already under way, this transfer—described in a recent 

report from consulting firm Cerulli Associates

—involves some 45 million U.S. households, many of which are those of high-net-worth individuals such as physicians.  

take care of the wealth they’ll inherit.

 Yet studies show that about 70% of  private legacies disappear by the end of the second generation after they’re bequeathed and about 90%, by the end of the third generation. The reason for this is that these heirs are far more focused on spending their inherited wealth than on preserving and growing it.

Understandably, they may not be capable of managing these assets themselves. But they also fail to make plans to hire quality advisors to do so—after firing the advisors who helped build the wealth they end up enjoying. Historically, nearly 66% of these heirs have fired their parents’ advisors, according to a study published in 

Advisors aren’t blameless in this. Surveys show that only a small minority of advisors seek to include the families of their clients in planning discussions so they can form a relationship.

No less at fault are the boomer parents. Many wealthy individuals fail to involve their grown children in legacy planning or even to introduce them to their advisors. This is part of a broader failure to discuss inheritance with their kids in any detail; surveys show that most don’t.

Because these lapses, the stage is set for legacies of the current, great wealth transfer to dwindle rather than be sustained. To avert this unfortunate outcome, late-career physicians with grown children should consider these steps:

Talk with your kids, fully and frankly. Impress upon them the importance of preserving and growing wealth to sustain it—for their use and for the use of their children.

To the extent that a skilled advisor has played a role in helping you build your wealth (which should have been the case all along), detail that role to your kids, outlining the various services involved and how they’ve resulted in asset protection and wealth accumulation. Show them copies of quarterly investment statements and advisor communications, and discuss their role—which they should have--as advisors for non-investment matters such as estate planning.

Explain what makes a quality advisor, including the principles followed by the advisor you work with. If this person is a fiduciary advisor (he or she should be, in your best interests), explain what this means: that the advisor is committed to always putting clients’ interests ahead of their own. This is only possible if advisors are serving clients’ interests rather than on earning lucrative commissions from selling clients the investment products they recommend—an inherent conflict of interest.

Emphasize that the relationship between client and advisor is really a partnership, sort of like a pilot and a co-pilot flying the aircraft of clients’ wealth. Explain what your role has involved in working effectively with your advisor, demonstrating that just because you have an advisor doesn’t mean you’re not personally accountable and responsible.

Involve your kids with your advisor at the earliest possible appropriate time. Opportunities for doing so are greatest if your advisor is a true wealth manager—someone who handles not just investments but also matters like estate planning, trusts and powers of attorney. If your advisor is setting up trusts for which your kids will be the trustees, it’s only natural to take them to these meetings.

If your advisor offers college-planning services, take your kids to meet him/her to set up investments for this purpose for your grandchildren’s educations. Thus, they can see the advisor in action and can become acquainted with him/ her, and possibly develop a relationship of their own.

For the benefit of your legacy, it’s essential to discuss with your grown children the financial consequences of your death and your spouse’s. It’s important that your heirs understand their responsibility for growing and protecting your bequests—for the benefit of their families and generations to come&mdash;and the importance of advisory relationships toward these goals.

	If you wait until you’re on your death bed, it’s virtually impossible to play catchup. Or, if you die suddenly without having “passed on” wealth-management values and your productive advisor, your legacy will probably suffer.

	If don’t feel your advisor has been truly helpful (and if that’s the case, why have you stayed with him/her?), then the challenge is to help your kids learn what to look for to hire one who’s a 

true fiduciary and a skilled wealth manager

	Otherwise, your legacy could be in jeopardy.

Early decision-making and direct conversation with your children are critical to passing on wealth properly when the time comes.

Author | David Robinson, CFP

Articles

Active and Passive Management Working in Harmony

Assessing Investing Impacts of the Great Decoupling

Prepare for the Next Black Swan with a Lifeboat Drill

Assuring Longevity for Family Legacies