The Blurry Line Between Active And Passive

by: Roger Nusbaum

Summary

A diversified portfolio likely includes both active and passive vehicles, owning any individual stocks is an active endeavor.

Rebalancing is arguably an active endeavor. A truly passive investor would let his allocation drift wherever.

The most important determinants to financial-plan success is an adequate savings rate, minimizing truly self-destructive behavior and living below your means.

By Roger Nusbaum, AdvisorShares ETF Strategist

Barron's had an interesting 'other voices' column titled The End Of An Active-Investing Era by Donald Callaghan. Most of the article was about the difficulty of outperforming the passive indexes. Active versus passive is not the point of this post, that's been written about 1000 times, other than to say there are too many real world variables to active versus passive for that to even be the right question.

A diversified portfolio likely includes both active and passive vehicles. Owning any individual stocks is an active endeavor, certain strategies use passive vehicles in active strategies. An 80-year-old client living comfortably off of Social Security and portfolio income is far more likely to care about that income while avoiding the market's ups and downs and there are other points that make active versus passive the wrong question.

What was more interesting was the conclusion with Callaghan's 'four key tactics'

  • Invest for the long term without market timing
  • Invest globally
  • Be Contrarian
  • Allocate to underperforming sectors

Read the article for more color on the four keys but three of the four are active ideas and even the fourth one could be considered active. Really, Callaghan's focus seemed to be on low fees, which would eliminate active managers from the portfolio, using index funds.

The first bullet point about not market timing is the one that isn't active but could be. Rebalancing is arguably an active endeavor. A truly passive investor would let his allocation drift wherever (a point made by Cullen Roche). You may not market time but you might time yourself. There is a school of thought that says a year or two before you plan to retire you should reduce equity exposure to reduce the impact of the bad luck that goes with a bear market starting six months after you retire. If that resonates with you then that is an active endeavor.

There are more active ways to invest globally than there are passive if passive means owning everything and never making a change. A broad index, like one that excludes Canada, or a smart beta index that only owns value stocks, or a country fund may all track indexes but they are likely being used actively. Colombia has at times been a great performing investment destination and at other times a lousy performer. There are several indexed ETFs tracking Colombia, a 3-4% weighting wouldn't be crazy, it would either outperform or underperform but the index won't go to zero. Colombia has less than a 0.52% weighting (that is where the individual country list ends and 'other' starts) in the ETF tracking the All Country World ex-US. You could substitute many other countries into the above sentence and have the same conclusion.

Whatever you think it means to be contrarian, regardless of whether you're using index funds, is an active strategy.

Buying cheap sector funds because they have been poor performers, like energy last February, would also appear to be contrarian and is definitely active.

All four of Callaghan's four keys are valid regardless of their suitability for anyone. The most important determinants to financial-plan success is an adequate savings rate, minimizing truly self-destructive behavior and living below your means. If your plan requires portfolio growth then you do need to stay close to the market, but managing your emotions is just as important as what you buy and how you buy it, even if that means sacrificing alpha.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com.

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