Active portfolio management attempts to generate returns that outperform a benchmark index by skilled investment managers. They utilize their skillset and judgement in buying and selling individual securities to outperform the benchmark index. Meanwhile, passive investors will argue that the best way to capture overall market returns is to utilize low-cost index-based investments.
Generate returns with active portfolio management:By picking the right investments, taking advantage of any market trends, and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index. This is possible by over or underweighting certain individual securities or industries in relation to a benchmark index. Holding more cash (conservative investment) and utilizing tax strategies compared to the index is also another example. These are attempts by the manager to add value to investment performance. However, constraints and limits on manager’s flexibility are constructed for the protection of the collective shareholders.
Capture overall market returns with passive portfolio management:Passive portfolio investors, also referenced as indexing, have argued that the best approach to capture market returns is to use low-cost market-tracking index investments. This approach is focused on cost and is based on the concept of efficient markets. Efficient markets state that investors have access to all necessary information about a company and its securities, making it difficult or outright impossible to gain an advantage over any other investor. Therefore, as new information becomes available, market prices adjust to reflect a security’s true value. Hence, reducing investment costs is key to improving net investment returns. Since no research is needed and trading is infrequent only when index structure changes, trading costs are lower. This also means fewer capital gain distributions and greater tax efficiency.
Blend both approaches with asset allocation:One way to obtain advantages of both methods is to employ a core/satellite approach. This method utilizes an asset allocation model to blend the “core” (bulk) of your investment dollars in cost efficient passive investments to capture market returns and the balance invested in a series of “satellite” (active) investments to potentially boost returns and lower overall portfolio risk. The idea is to choose low-cost core holdings to track a specific benchmark and add value with satellites to either enhance return or reduce portfolio risk.
Whatever method an investor chooses, they will need to weigh their financial goals, the time horizon necessary to achieve those goals, and risk tolerance based on historical return into their strategic long-term asset allocation approach. This can be coupled with a shorter-term, tactical asset allocation approach which tends to be more opportunistic and short-term in nature.
As always, if you have any questions or concerns regarding active versus passive portfolio management, please reach out to your First Bank Wealth Management Team.
Brian Lescar, CFP®, AAMS®, LIFA is a Vice President and Portfolio Manager for First Bank Wealth Management. With over 30 years of experience in financial services and a deep knowledge of investment management, you may contact Brian Lescar at (419) 309-4396 or via email at [email protected].