Active vs. Passive

In this week’s blog post, we wanted to touch on a frequently debated topic in the investment community, namely passive vs. active investment management. Passive investment strategies seek to replicate the composition and returns of an index or benchmark for a low cost (S&P 500 for example). Active investment strategies require teams of investment professionals conducting substantial due diligence and research on potential investments with the goal of outperforming a specific benchmark.

The active vs. passive investment style debate has only grown stronger since the financial crisis. This is due in large part to the high percentage of active mutual fund managers who have underperformed their relative benchmark since the market downturn in 2008.

We at Harbor embrace both sides of this debate and are using a mix of passive and active investment strategies in our model portfolios. We’ve compiled a few tips below to help the investor gain some clarity on this issue:

Know how much you are paying – this may sound like a no-brainer, but begin the analysis by reviewing your existing portfolio underlying fund fees. This data can be obtained from your advisor, custodian or the fund company directly.

Review your risk tolerance – sometimes we just need a reminder to revisit our risk tolerance and compare to our existing portfolio allocation. If your circumstances have changed there is no better time to make an adjustment than after a period of strong market performance. Plus, this refresher may help you focus your research on active vs. passive strategies.

How active is your active manager? Proponents of passive investing have long highlighted the difficultly of beating an index over time due to costs of active management. What if your active fund manager really was just a ‘closet indexer’ and you were paying significantly higher fees for nothing? Enter the term active share – a measure of the portfolio allocation that differs from the benchmark. Studies conducted in academia have found that successful active managers should exhibit an active share between 60-100% to provide value over an index strategy. This is an important statistic because if the manager is a closet indexer, it will be very difficult to outperform the benchmark net of fees simply because one cannot invest directly in an index.

Who’s behind the article? Asset management is a very large industry representing billions of dollars in annual revenue worldwide. Make sure you understand who has authored the article and what their agenda may be.

How to compare performance? Most mutual funds and ETFs will report performance net of fees and expenses to the individual investor. Index returns do not include fees and expenses, therefore be aware that you may be comparing net of fees vs. gross of fees in a performance review.

Want to learn more? Call or email us! We regularly follow this debate and are available to discuss anytime. Also, we will be posting a white paper on this topic in the near future.