Active vs. Passive Investing - Some Thoughts

A reader left a comment asking for my take on active versus passive investing, with all sorts of snippets about how active lags passive and then asked how I address this with prospective clients.

I almost wonder if the person is in the business. I will try to answer this without making too salesy.

Hopefully you read the comment (linked above) and at least a few of the factoids. The reader frames the question differently than how I approach performance and what it is I am trying to do.

The reason people invest is so they have enough money when they need it and for what they need it for, usually retirement. An idea I have expressed before: a 62 year-old does not look back to when they were 48 and lament that as a bad year or celebrate it as a good year. The goal as I see it, starting big picture first, is giving someone the best chance of having enough money when they need it.

I have settled in on trying to miss big chunks of down a lot as a means of trying to add value over the entire stock market cycle. I have unyielding faith that something involving the 200 DMA is the best chance to make that happen. When the market is going up I am just trying to capture most of the effect. Someone who is at least mediocre can count on lagging some up years and beating some up years. If the up years net out as a push and I can avoid a chunk of down a lot, I have not only a chance of adding value for the client, but also of smoothing out the ride for the client.

One other aspect of the reader's comment needs addressing. All of the factoids he left are about actively managed mutual funds which have a skew that might put them at a disadvantage versus someone who does what I do.

A mutual fund manager should assume that anyone buying the fund they manage has already made the stocks/bonds/cash allocation decisions. That manager should assume that when someone buys $20,000 into his large cap value fund that the person wants $20,000 put into large cap value.

Obviously there are funds that have large cash balances, but there is nothing wrong with a fund manager assuming the money he is given should be invested. If you are down less than the market this year or since the peak in October, is it because of superior stock picking, or because you raised some amount of cash? It is much easier to outperform a bear market by raising cash than picking better stocks.

There may also be a skew in this sort of research because of how many OEFs there are. There are thousands of them, and most of them are actively managed. With a universe that big I think it would be more difficult to find outperformers.

Lastly, there may be an issue in the stats cited by the reader of proper benchmark comparisons. Some of the studies cited compare everything to the S&P 500 - which is the wrong thing to do. Barron's does this all the time, but comparing a small cap fund to the S&P 500 (or other similar examples) makes for unreliable data.

I am not saying that it is easy to beat the market. I am just naturally skeptical of all sorts of market research and maybe it is not as difficult as some studies would have us believe. Maybe instead of 10% beating the market over long periods, it is closer to 30%? I have no idea about the reality, and I don't really care.

One thing missing even still (there are probably many gaps in this post) is strategies that try to, for example, capture 80% of the upside with only half the downside so a risk adjusted result that is not even about trying to beat the market. How many funds like that (absolute funds) are there and are they included?

We try to do what we try to do. Other RIA's try to do what they try to do. I think that an RIA who generally does what they say they are trying to do is likely to add value for his clients.

Comments

[irondoor91:]

Roger,

I am in the business as both a RIA and manager of a small hedge fund. I have been reading your posts for a while and generally agree with your approach for investors and especially those approaching retirement. It is very hard to make money in the markets, and it is very easy to lose it and lose it quickly. Using a moving average technique to allocate assets into or out of the equity or bond markets is as good as any "rocket scientist" method devised on prop trading desks. Using individual stocks, ETF's or active mutual funds to implement is a matter of preference and the comfort level of the investor and advisor.

You offer good, sound perspective. The best thing to do for yourself and your clients is to stick to your knitting and what got you to where you are today. It is very easy to get flushed out with these 300+ point moves on a daily basis.

So diversify and consider using one of more of the new short or double short EFT's to hedge if you or your client is uncomfortable with volatility or direction.

2008 Sep 22 11:27 AM

[iknoknot:]

"down-in-the-noise" vs the real "down-a-lot" - therein lies the art.

thanks for a good read.

--ikk

2008 Sep 23 04:29 AM