We all grew up with the tale of Paul Bunyan vs the steam powered saw. Paul Bunyan and his Blue Ox, Babe, battled the new piece of lumberjacking technology in a contest of logging efficiency. Man ending up persevering over the robot but is that the case in the investment world? As cost becomes a more relevant theme to your net investment return, is investing in an index-tracking investment or trusting an experienced manager better for your bottom line? A portfolio can benefit from both active and passive management strategies.
Passive management primarily uses exchange traded funds and index mutual funds to track a particular index. Indexes can be as common and broad as the S&P 500 and the Dow Jones Industrial Average or as specific as a sector of a small Southeast Asian country. The combination of stocks in the index is predetermined which help keep down the internal expenses. If there are changes in the index, the management company does it best to track the change in the most timely and accurate way possible. Therefore the ETF or fund returns should be extremely similar to the index returns.
Active management relies on the experience and expertise of a team to trade securities within their own strategy or philosophy. Some managers chose to run their fund close to the index and others have huge variations from their peer group. Given the amount of research and manpower it takes to run an active fund, the expenses are most times higher than a passive manager. Active management relies on the premise that the value add for an active management team is worth the added expense.
So which is better? Investors that favor passive management point to data that shows the majority of active managers underperform their particular index in a particular time period. Investors who find value in active management will use the track record of a management team to justify the added cost. The correct answer is a personal decision based on your clearly defined your goals, objectives, risk tolerance, and action plan. If cost is the most important concern, then a portfolio that is passively managed will aim to grow your wealth with the least amount of fee drag. If you feel more comfortable trusting a management team in a particular asset class or part of your portfolio, then the additional cost will be justified if you pick the right manager. Many times both strategies can be implemented together to keep the cost down in areas where there isn’t a huge upside beyond the index and to gain value in parts of your portfolio where there is an increased opportunity for a manager to outperform the index.
Both sides need to come together in a bipartisan agreement that both management styles can work harmoniously in unison to help an individual grow their assets in the most effective way possible. Just as the active managers would be foolish to ignore the impact of fees on net return, it would be imprudent for the passive investor to discount the value add of a competent management team. The correct combination of the human touch to efficient technologies is the optimal blend.
Investing in mutual funds and ETFs involves risk, including possible loss of principal. Value will fluctuate with market conditions and may not achieve its investment objective. Index investing involves risks including index tracking errors. Investments concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly. No strategy assures success or protects against loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Daniel Aguanno is a CERTIFIED FINANCIAL PLANNER™ (CFP®) professional and holds his series 7, 66 registrations through both LPL Financial and Private Advisor Group along with his life and health insurance licenses. He works at the Bleakley Financial Group and can be reached at 973-575-4180 or email@example.com.
About the Author
Daniel Aguanno, CFP®
Daniel Aguanno has been assisting his clients in working toward financial security since 2007. The financial planning process begins with an initial meeting to clearly define what is important to each client. After specific goals are agreed upon, Dan and his team develop customized financial planning strategies to address each objective. Through the implementation of independent recommendations, Dan ensures his clients stay on track with their financial plan.