Active and Passive Management Working in Harmony

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 RTS Private Wealth Management, 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.