Active vs. Passive Portfolio Management
One of the longest-standing debates in investing is over the
relative merits of active portfolio management versus passive management. With
an actively managed portfolio, a manager tries to beat the performance of a
given benchmark index by using his or her judgment in selecting individual
securities and deciding when to buy and sell them. A passively managed
portfolio attempts to match that benchmark performance, and in the process,
minimize expenses that can reduce an investor's net return.
Each camp has strong advocates who argue that the advantages
of its approach outweigh those for the opposite side.
Active investing: attempting to add value
Proponents of active management believe that by picking the
right investments, taking advantage of market trends, and attempting to manage
risk, a skilled investment manager can generate returns that outperform a
benchmark index. For example, an active manager whose benchmark is the Standard
& Poor's 500 Index (S&P 500) might attempt to earn better-than-market
returns by overweighting certain industries or individual securities,
allocating more to those sectors than the index does. Or a manager might try to
control a portfolio's overall risk by temporarily increasing the percentage
devoted to more conservative investments, such as cash alternatives.
An actively managed individual portfolio also permits its
manager to take tax considerations into account. For example, a separately
managed account can harvest capital losses to offset any capital gains realized
by its owner, or time a sale to minimize any capital gains. An actively managed
mutual fund can do the same on behalf of its collective shareholders.
However, an actively managed mutual fund's investment
objective will put some limits on its manager's flexibility; for example, a
fund may be required to maintain a certain percentage of its assets in a
particular type of security. A fund's prospectus will outline any such
provisions, and you should read it before investing.
Passive investing: focusing on costs
Advocates of unmanaged, passive investing — sometimes
referred to as indexing — have long argued that the best way to capture overall
market returns is to use low-cost market-tracking index investments. This
approach is based on the concept of the efficient market, which states that
because all investors have access to all the necessary information about a
company and its securities, it's difficult if not impossible to gain an
advantage over any other investor. As new information becomes available, market
prices adjust in response to reflect a security's true value. That market
efficiency, proponents say, means that reducing investment costs is the key to
improving net returns.
Indexing does create certain cost efficiencies. Because the
investment simply reflects an index, no research is required for securities
selection. Also, because trading is relatively infrequent — passively managed
portfolios typically buy or sell securities only when the index itself
changes — trading costs often are lower. Also, infrequent trading typically
generates fewer capital gains distributions, which means relative tax
Before investing in either an active or
passive fund, carefully consider the investment objectives,
risks, charges, and expenses, which can be found in the prospectus available
from the fund. Read it carefully before investing. And remember that indexing — investing in a security based on a certain index — is not the same thing as investing directly in an index, which cannot be done.
Blending approaches with asset allocation
The core/satellite approach represents one way to employ both approaches. It is essentially an asset allocation model that seeks to
resolve the debate about indexing versus active portfolio management. Instead
of following one investment approach or the other, the core/satellite approach
blends the two. The bulk, or "core," of your investment dollars are kept in
cost-efficient passive investments designed to capture market returns by
tracking a specific benchmark. The balance of the portfolio is then invested in
a series of "satellite" investments, in many cases actively managed, which
typically have the potential to boost returns and lower overall portfolio risk.
Bear in mind that no investment strategy can
assure a profit or protect against losses.
Controlling investment costs
Devoting a portion rather than the majority of your
portfolio to actively managed investments can allow you to minimize investment
costs that may reduce returns.
For example, consider a hypothetical $400,000 portfolio that
is 100% invested in actively managed mutual funds with an average expense level
of 1.5%, which results in annual expenses of $6,000. If 70% of the portfolio
were invested instead in a low-cost index fund or ETF with an average expense
level of 0.25%, annual expenses on that portion of the portfolio would run $700
per year. If a series of satellite investments with expense ratios of 2% were
used for the remaining 30% of the portfolio, annual expenses on the satellites
would be $2,400. Total annual fees for both core and satellites would total
$3,100, producing savings of $2,900 per year. Reinvested in the portfolio, that
amount could increase its potential long-term growth. (This hypothetical
portfolio is intended only as an illustration of the math involved rather than
the results of any specific investment, of course.)
Popular core investments often track broad benchmarks such
as the S&P 500, the Russell 2000® Index, the NASDAQ 100, and various
international and bond indices. Other popular core investments may track
specific style or market-capitalization benchmarks in order to provide a value
versus growth bias or a market capitalization tilt.
While core holdings generally are chosen for their low-cost
ability to closely track a specific benchmark, satellites are generally
selected for their potential to add value, either by enhancing returns or by
reducing portfolio risk. Here, too, you have many options. Good
candidates for satellite investments include less efficient asset classes where
the potential for active management to add value is increased. That is
especially true for asset classes whose returns are not closely correlated with
the core or with other satellite investments. Since it's not uncommon for
satellite investments to be more volatile than the core, it's important to
always view them within the context of the overall portfolio.
Tactical vs. strategic asset allocation
The idea behind the core-and-satellite approach to investing is somewhat similar to practicing both tactical and strategic asset allocation.
Strategic asset allocation is essentially a long-term approach. It takes into account your financial goals, your time horizon, your risk tolerance, and the historic returns for various asset classes in determining how your portfolio should be diversified among multiple asset classes. That allocation may shift gradually as your goals, financial situation, and time frame change, and you may refine it from time to time. However, periodic rebalancing tends to keep it relatively stable in the short term.
Tactical asset allocation, by contrast, tends to be more opportunistic. It attempts to take advantage of shifting market conditions by increasing the level of investment in asset classes that are expected to outperform in the shorter term, or in those the manager believes will reduce risk. Tactical asset allocation tends to be more responsive to immediate market movements and anticipated trends.
Though either strategic or tactical asset allocation can be used with an entire portfolio, some money managers like to establish a strategic allocation for the core of a portfolio, and practice tactical asset allocation with a smaller percentage.
Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.