Unless an investment portfolio features both passive and active assets, or sources of income, it cannot be described as being fully diversified. When investors set out to diversify their portfolio holdings, they mostly think about evaluating various sectors, but the underlying style of investment will almost always remain fully active or passive.
Even fund managers tend to completely favor one style of investing over the other, and most of them are leaning towards passive investing trends these days because of the bullish streak Wall Street has been on since 2010. There was a time when fund managers preferred active investing because it involved more research that justified higher fees; however, the advent of financial trading technologies allows greater investment automation that results in lower management fees.
The Efficient Markets Theory
Active investing is better suited when market conditions are not as efficient as normally desired, which means that the flow of financial information is not as rapid or widely available as it is on Wall Street, a market that is becoming more and more efficient each day. Market efficiency is a major reason that explains today’s passive investing trend.
Outperforming the Market versus Following an Index
Fund managers who have passively followed the S&P 500 in recent years have enjoyed positive returns while saving their clients’ money on fees. Many active portfolio managers, particularly those who oversee hedge funds, have outperformed the market because they have taken risks investing in “hidden gems” or even taking short positions. Needless to say, many other active managers have taken risks that have resulted in losses underwritten by higher fees paid by clients.
Combining Passive and Active Investing Strategies
There are no rules that tie investors to active or passive strategies; in fact, investment analysts recommend including both strategies in a portfolio. The higher costs associated with active investing are not the same across the board. Investors can find competitively priced funds that focus on emerging markets, for example, and they may also evaluate products managed by large fund companies that keep their fees low for the purpose of attracting more clients.
Exchange-traded funds that track index performance tend to be ideal for efficient markets, but investors have to accept that these securities can also post losses. Let’s say a passive investor adds an ETF that tracks the Dow Jones Industrial Average to her portfolio just before Wall Street goes through a major market correction; in this scenario, a 10 percent loss is very likely.
As previously mentioned, many active investors have enjoyed excess returns even during the bull market of recent years, but not all of them have done so. A portfolio filled with nothing but active investing strategies would be too risky, and this fits the description of quite a few hedge funds that have mostly generated losses at a time when index funds are sailing smoothly for investors.
In the end, choosing the best of both investment worlds is recommended for 2018. A nice mix of active and passive investing strategies can work wonders for investors who are interested in balancing their portfolios.
Davenport Laroche is a shipping container investment agency.