Active Investing v Passive Investing? It’s a secondary decision in my book

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What should an investor do, opt for a passive investment strategy or go with a more aggressive actively managed strategy?

This is a tough question to answer and the debate will rage on and on and on and on. There are alot of powerful interests, with alot of money, on both sides of this debate, both fighting tooth and nail to debunk the other.

For the better part of three decades, from the early 1970’s through the 1990’s, actively traded mutual funds ruled the roost (this was really the only game in town)

Emergence of ETF’s

In the last 10 years the investing landscape has changed dramatically, with stiff competition now coming from ETF’s. Actively managed funds are competing for their livelihood, with ETF’s capturing an ever increasing share of their market. What does that tell you?

It tells me that more and more individuals and financial advisors are moving to ETF based portfolios. I’ve stated publicly, for the most part, I use ETF’s in our client portfolios. A few days ago I told you I get calls from mutual fund wholesalers that want to know about my business…. 5 years ago I would have to explain alot more to them than I do today.

Today, as soon as I say, “I have an ETF based business…” they have a good idea what I’m going to say next. Why? Because they are hearing it more and more from the advisors they call on.

Choosing the right investments

Now, I’m not hating on all actively managed mutual funds. There are some great (tax efficient) mutual funds and I use some of them, especially in retirement accounts. But you have to be very careful in choosing these funds and understand how to pick the best ones. I will show you what to look for when I get into mutual fund week. (hopefully, next week)

Let’s play devil’s advocate for a couple paragraphs… Heck, if you’re invested in a fund that has handsomely outperformed its benchmark, than who cares about high expenses and internal fund trading costs, right? It happened all over the place in the late 1990’s and 2000.

In 1999 and 2000, there were funds with 100%+ returns for that year. Maybe there expenses were 25%, but whose going to complain about netting 75%? (actually, some people did; a sign (anecdotally) there was big trouble on the horizon)

A justifiable reason

In fact this week, a good friend of mine that sells actively managed funds, was telling me about a favorite fund that he sells, which has excellent returns, with slightly more than half the market volatility of the benchmark index (i.e. S&P500) it competes against.

There is a lot to be said for that kind of reduced volatility. If a fund can compete, performance wise, and provide a much smoother ride, than I can see how that makes good sense for investors. It’s important to be objective here.

What to do?

At the end of the day, there is SO SO much noise out there and I truly sympathize with the individual investor (another reason why I’m blogging here). You get so many different viewpoints that are diametrically opposite, but at the same time, presented so eloquently, on CNBC, Bloomberg, The Wall Street Journal, etc. when it comes to stocks, bonds, mutual funds, the markets, the economy and so on.

How the hell do you know what to do? Well here’s what it boils down to for me.

There are two things that dictate my decision to heavily invest client monies in ETF’s:

• It’s Math! Statistical analysis! - You all remember that class, right? In my opinion, the probability favors ETF’s in the long run. In most market categories, most mutual funds under-perform their benchmarks over the long haul. Even if actively managed funds beat the benchmark, they usually lose in the end after fund expenses, marketing costs, tax inefficiencies and trading costs are taken into consideration.

So, if you tell me I have a 75% chance of success behind Door#1 or 25% chance of success behind Door#2… which door am I going to walk through? I choose to walk through Door#1.

• Relative Performance - Lastly and most importantly, in my last post, I alluded to the decision whether to choose passive or active as being a secondary decision. What did I mean by that? Well, for me, absolute performance is secondary, I’m looking for investment success in the context of our financial plan. Looking for absolute performance is a foolish man’s game, it often results in more risk exposure than is prudent.

I let the financial plan dictate the type of investment portfolio we’re going to put together. If the plan tells us we need an 8.9% return from our investments, then that’s what we will be shooting for. Something an ETF based portfolio is very capable of achieving.

End of story…

Tags: Active v Passive Investing, ETF, ETF Based Portfolio, Featured, Relative Investment Performance