Many people think the key to successful investing is market timing and choosing the right stock. However, in my experience, the most important aspect of wealth accumulation is asset allocation. The challenge is knowing where to pull those assets from to fill your portfolio.
If you believe that asset allocation is the best way to build wealth over time in your portfolio, rather than trying to identify the next up-and-coming stock (something many top-level executives just don’t have the time to do), you have a few options. You can fill your investment portfolio with actively managed mutual funds, passively managed index funds or exchange-traded funds (ETF), or a combination of them all.
All of these options will give you nearly instant diversification because they hold numerous assets within each fund, which is much more convenient for an individual investor. For example, if you wanted to invest in the 500 largest companies on the stock exchange (S&P500) and you didn’t use a fund that held those stocks, you would have to buy each stock individually and rebalance as companies come and go from the top 500 list.
So knowing that both active and passive investing can help you achieve portfolio diversification and asset allocation, which one is right for you? Here’s a look at the differences between active vs. passive investing, industry trends around both of these types, and ways to determine which one makes most sense for your portfolio.
The Differences Between Active vs. Passive Investing
Let’s start with the differences between these two strategies.
An active investment strategy attempts to outperform major indexes within the asset class that they are investing in. For example, an actively managed equity fund would attempt to outperform the larger stock index of the S&P 500 or some other stock index that best reflects the investment strategy.
On the flip side is passive investing, or in most cases, investing in passively managed funds (index funds or ETFs are most popular). Passively managed funds seek to mimic and reflect the index that it is tracking as closely as possible. Again in our example, a passively managed fund reflecting the S&P 500 would seek to match the returns and performance of the top 500 stocks on the exchange as closely as possible.
The major benefits of passively managed funds are the low cost or low fee structure. Because the fund itself is just seeking to match the performance of the underlying index, it does not need to over analyze or complete active research to do so, therefore lowering the overall cost to operate the fund. The cost savings incurred by the fund itself is passed on to investors, lowering their overall cost of doing business in their investment portfolio.
Actively managed funds, on the other hand, have higher fees on average and complete market analysis in an attempt to outperform the correlating index. Passive investment proponents would say that lowering fees and overall asset allocation are key factors in building wealth. Meanwhile, those passionate about active investment would say that outperforming the status quo in the long run will give you better-than-average results.
Active and Passive Investing Trends
When deciding between these two investment strategies, looking at where new money seems to be headed can be an indicator of where investors are seeing the greatest returns. It can also just be a reflection of current public opinion.
About a decade ago, roughly 20% of investable assets were held in passive investment funds, such as index funds or ETFs. Over the years, that number has grown. Now, it’s around 33% of investable assets. As that number has increased, money has moved from actively managed funds into passively managed funds to the tune of about $500 billion in the first half of last year alone.
Another trend to note is that financial advisors are one of the large reasons why capital seems to be flowing from active to passive funds, rather than individual investors, which the index funds were originally designed for. Vanguard was the first to introduce an index fund, and it recently reported that more new money comes in via advisers than directly from retirement plans or individuals. This means that more advisors are investing their clients’ money in passive funds, further backing the trend of adopting this strategy. In fact, Vanguard founder Jack Bogle said that he believes passive investing could eventually account for 90% of the equity market.
All of this is to say that passive investing seems to be on the rise. However, there will likely always be a time and place for active investing, as well. In my experience in the investing world over the years, I have noticed that active managers become more popular in down markets while passive investing is more favorable in up markets. When everything is going well, the indexes perform well. However, when the market takes a downturn, people look to experts (active fund managers) for advice on where to find positive returns.
Is Active or Passive Investing Best for You?
So which of these two investing strategies make sense for your portfolio?
As a corporate executive, you are likely very familiar with risk management, asset allocation, and diversification strategies. These are all factors to consider when designing and managing your own investment portfolio. As a wealth manager, I think it is best to consider your goals and desired outcome before making a decision on whether or not you want to pursue an active or passive investment strategy for your portfolio.
If you believe that the market overall will experience growth over the next few decades, an index fund or ETF should be able to suit your needs and embrace the passive investment philosophy.
If you wish to invest in alternative asset categories, such as the commodity market, to hedge against some of your stock holdings, then an actively managed fund might be a good fit for that goal and desired outcome.
The definitive answer here is that there is no definitive answer. Seeking out the help and insight of experienced counsel in the investment space is the best first step you can make. Be sure to work with an advisor who can help guide you through the process of setting investment goals and developing a strategy around those goals.
As a top-level executive, you will need to factor in your equity compensation along with your concentrated stock position that you have accumulated if you participate in employee stock options. Overall, your investment style will be guided by your unique situation and goals, in which both active and passive investing will likely have a role in your portfolio.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for asset allocation and equity compensation planning. For more information on how Wade and the Carpenter Team can advise you on active vs. passive investing, reach out today for a complimentary consultation.
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