When it comes to choosing a financial advisor to manage your investments, your choice will usually boil down to A) an advisor that falls more on the passive end of the investment spectrum or B) an advisor that follows a more active approach and is considered a stock-picker or market timer.
Of course, there are other very important considerations as well when making this decision such as:
- Does your advisor work on a fee-only basis? (we do)
- Does your advisor avoid any conflicts of interests by intentionally and proudly choosing to be an advocate for their clients best interests by working in a fiduciary capacity? (we do)
- Does your advisor provide full transparency around their management fee and send a quarterly investment performance report that is understandable and simple to read and figure out? (we do)
- Does your advisor focus on tax efficiency when constructing and managing your portfolio? (we do)
When I read about the poor showing of active stock-pickers in the recent Wall Street Journal article, was there some schadenfreude on my end? Yes indeed. Let me explain.
At institutional investor and financial planning association conferences held around the country, attendees will usually feel like you’re on one team or the other. There are the advisors that choose to use a passive approach to investing by utilizing index funds and ETF’s that replicate market indexes, like the S&P 500 Index Fund for example.
And then there’s the other team that usually has a bit of swagger as they strut their stuff around the conference. This team believes that they can beat the market and indexes by actively choosing which stocks to buy.
And in the small middle, are hybrid advisors that use a little of both styles.
The “actives” vs. the “passives”; deciding which is a better strategy to employ for your clients - that debate has been raging for decades and I assume will continue on for decades to come. The actives believe we passives are missing great opportunities to beat the market.
Many in the active camp think what we do and how we do it is about as much fun as watching paint dry. And many of us in the passive camp think attempting to beat the market by superior stock picking or market timing is a fool’s errand meant to enrich the advisor that works on commission at the expense of the client.
The actives hold the legendary Peter Lynch that ran the Magellan Fund at Fidelity from 1977-1990 and averaged a 29% return as their standard bearer. We passives hold up luminaries like John Bogle, the founder of Vanguard and Warren Buffet as our icons.
The Proof is in the Pudding
“According to Lipper, around 85% of active large cap stock funds have lagged their yardsticks this year and it's their worst showing in three decades. If professional stock pickers are collectively this bad during a good stock market, how bad are they during a bad market?”
“Never mind how the S&P 500 is about to record its fifth consecutive yearly gain and ninth gain out of the past 10 years. Even with the wind in their sails, professional stock pickers still can't beat market indexes or the ETFs tracking them.”
Both of these quoted paragraphs above came from another recent article published by Seeking Alpha, the very popular personal finance site for active stock pickers.
Does this mean that deploying a passive investment strategy will always beat an active approach?
But for example, when usually only 3-4 actively managed mutual funds out of 10 beat their passively managed counterparts, why take the risk of thinking you’ll know which 3-4 actively managed funds will be the winners?
Instead of Seeking Alpha, Seek Value
When we talk to clients about our value proposition, it’s in a few areas where we have a lot of control-risk, managing costs and taxes and disciplined rebalancing. For many of our clients, taxes may be their largest expense and the changes to the tax code that took effect in 2013 makes our focus on tax efficiency even more valuable.
We have a lot of control over the tax efficiency of the portfolio just by implementing relatively simple strategies such as asset location (putting the right assets in the right accounts), managing the turnover of the portfolio, tax-loss harvesting, planning the timing of capital gains recognition or distributions from tax deferred accounts and gifting appreciated securities.
In terms of managing portfolio costs, as the saying goes, markets are unpredictable but costs are forever. The lower your costs, the greater your share of an investment’s return. Minimizing costs is a core principle of our investment management process. That’s because with investing, there is no reason to assume that you get more if you pay more.
Instead, every dollar paid for fund management fees or trading commissions is simply a dollar less earning potential return. The key point is that-unlike the markets-costs are largely controllable.
Indexing Can Help Minimize Costs
If—all things being equal—low costs are associated with better performance, then costs should play a large role in the choice of investments. Index funds and indexed exchange-traded funds (ETFs) tend to have costs among the lowest in the mutual fund industry.
As a result, indexed investment strategies can actually give investors the opportunity to outperform higher-cost active managers—even though an index fund simply seeks to track a market benchmark, not to exceed it. Although some actively managed funds have low costs, as a group they tend to have higher expenses. This is because of the research required to select securities for purchase and the generally higher portfolio turnover associated with trying to beat a benchmark.
Still not convinced passive investing vs. active investing is the smart and winning way to go, then check out Vanguard's 5 Myths and Misconceptions About Indexing, and my guess, sooner rather than later, you’ll be on our team.