By Kash Pashootan
As financial market conditions continue to be volatile due to global economic headwinds, there has been much talk recently about a recurrent debate: does active or passive portfolio management deliver better results. There is a view held by some that the average portfolio manager will underperform index benchmarks, suggesting that it is best to ride the market with a passive management approach by investing in index tracking exchange traded funds. However, active and passive management do not need to be mutually exclusive, as both can be complementary in forming a personalized portfolio strategy. The question becomes where and when is one approach more appropriate than the other. Where portfolio managers add real value is in determining which style is best to use in light of inherent merits and drawbacks of each investment approach and the objectives of individual investors.
Index Distortion and Negative Compounding
Over the past several years markets have been characterized by periods of extreme volatility. Active managers do well by focusing on company fundamentals rather than treating equity as an asset class. During periods of lower return, owning an index carries more risk as market cap-weighted indices are distorted. In extreme market conditions, unprecedented valuations of stocks and inflated market caps cause sector weighting to rise, thereby eliminating diversification. This was the case in late 1990s when inflated valuation of tech stocks caused the technology weighting in the Russell 1000 Growth Index to balloon to 44 per cent, only to endure the sector’s loss of 35 per cent in 2000 as the tech bubble burst. Index distortion can be observed today, as the weighting of Apple Inc. has increased to 4.44 per cent of the S&P 500 Index. Market cap-weighted indices are inherently momentum driven, allocating to stocks that have recently done well and are now overvalued. It is at this time that active managers take advantage of the opportunity to make a diversification judgment by trimming overvalued sectors and investing in stocks trading at rarely seen valuations. The ability of active management to preserve capital in down years adds greater value than outperforming in up years due to effects of negative compounding. Conversely, passive investment management does not offer any down-market protection. In addition, index funds will inevitably underperform the benchmark due to embedded fees. With no capital protection during periods of negative market performance and the compounding of embedded fees, a passive strategy can increase the risk of capital erosion and when losses are incurred the return needed to just regain your starting capital can grow significantly.
One of the key determinants in overall portfolio strategy selection is the duration that assets are invested and not withdrawn. Short-term investments of one to three-year periods are subject to market noise. In this context, a passive approach can, in certain market conditions, provide a quick and effective way for investors to gain exposure to the market, steering clear of high transaction costs. In contrast, to realize true value of active investment management the holding period must allow for at least one full market cycle of three to five years. Studies show that active management can accrue benefits and add value over the benchmark as the time horizon is extended through market cycles.
In the investment management industry, active management comes in many forms and with managers of varying skill. There is a vast difference between average and above-average managers, with a direct impact on portfolio performance. Top managers have been found to consistently add value in both up and down markets with a disciplined, repeatable investment process. For investors, due diligence is a critical part of portfolio manager selection and in many ways it is analogous to picking a good stock. The account fee structure must also be considered. Commission accounts carry inherent conflict of interest by compensating portfolio managers on a per trade basis. In comparison, fee-based accounts align the interests of the client and the portfolio manager. By charging a fee on total assets under management, the structure ensures that both parties have equal interest in growing the capital.
When choosing an appropriate portfolio management strategy, investors need to consider their expected time horizon, tax sensitivity, and ability to tolerate performance variation. A portfolio manager can help you weigh the merits and drawbacks of each strategy, while taking into account your investment objectives to determine which approach is most appropriate for you.
Kash J. Pashootan is a Vice President and Portfolio Manager with Raymond James Ltd. Information provided is not a solicitation and although obtained from sources considered reliable, is not guaranteed. The views and opinions of the author do not necessarily reflect those of Raymond James Ltd. Member Canadian Investor Protection Fund.