Whether you are an experienced investor or just beginning to learn how to invest, you have probably heard from blogs, videos, books, and podcasts that active management is a fool’s game. You have probably heard that a low-cost index fund like the S&P 500 should be the only investment in your portfolio and to just “set it and forget it.” For efficient markets, like U.S Large Cap stocks (America’s biggest companies), this can certainly be the case, but…Does it apply to ALL asset classes? Does it even apply to all market conditions? At MDRN Wealth we believe that combining passive strategies, like a simple low-cost ETF that mirrors the S&P 500, with active strategies is the most optimal way to balance risk and create greater efficiency in your portfolio.
Here is why:
Inefficient Markets vs. Efficient Markets
Let’s look at the U.S Large Cap stock market. One of the ultimate measures of this market is the S&P 500. If you look at the S&P 500, America’s biggest names have the most impact on the performance of the index. When we look at these companies, there is no secret to their underlying business models and valuation. Their prices are true to the information that is out there. This is what is known as Efficient Market Hypothesis. However, does this apply to all markets? We believe it does not. For example, in the U.S Small Cap stock market, these are smaller U.S companies, that are still growing. These are names that you may not recognize but perhaps one day you will. In an asset class like this where there is less analysis coverage, it creates an opportunity to find more diamonds in the rough.
Another reason for incorporating active funds within your portfolio is that, by design, active funds are going to be able to do things that a passive fund simply cannot. Let’s look at bonds for example. For a moment, let’s think about what a bond is. It is at its essence an IOU from an institution or entity. Now, if someone were to owe you money, wouldn’t you want to ensure that they weren’t at risk of defaulting on their debt? Would you want to lend to someone that has the most IOUs issued in the country? Probably not, but that is effectively what happens when you buy a bond index fund. You wind up with companies who have issued the most amount of debt, and there also isn’t much being done to ensure they don’t default. This is one reason why we incorporate actively managed bond/credit strategies within our portfolios. You can not only help mitigate these risks but you can also find opportunities in credit markets with active research. For example, maybe a company issued a bond that has a highly attractive interest rate, but they are just barely below being considered investment grade. With due diligence and research of that company’s balance sheet, you find that they are in for real growth and their financial shape is likely to get stronger in the future.
Location, Location, Location
One of the major criticisms that active funds receive is that, even if they can be stronger performers than their index/passive counterparts, they are less tax efficient and, as such, may erode returns. Therefore, asset location matters just as much as asset allocation. When designing your portfolio tactically, placing funds in accounts based on that account’s tax efficiency and time horizon will help reduce potential tax liability associated with active funds. It will also help promote liquidity in accounts that you may need to tap into sooner rather than later. For example, perhaps using a particular small-cap active manager makes sense over using an index-based small-cap fund. The active small-cap fund may have heavy capital gains associated with it. To mitigate this, you place it in a qualified retirement account. Maybe you are 10-plus years away from retirement and can afford to take more risk with a small cap fund in this account, plus you need not worry about capital gains distributions since you placed it in a qualified retirement account.
Say Goodbye to Active vs. Passive
There is no reason why active and passive investments cannot co-exist within the same portfolio. The question isn’t Active vs. Passive. The important questions to ask are:
- “What asset classes should use passive/active?”
- “How much of one versus the other?”
- “What accounts should they be placed in?”
This is where your comprehensive financial plan will help dictate the direction of your portfolio and the assets that you are using. If you haven’t worked with a financial planner to set one up, feel free to book some time with us to discuss getting started.