Cody Sims: Does your portfolio have room for active and passive investments?
Investors today live in an era of unprecedented global investment choices, both active and
passive vehicles. Investments in each category present opportunities and challenges for investors
consider when developing an optimal financial strategy. With so many choices at your fingertips, how do you get the most out of what the markets have to offer? There’s no right answer for everyone, but in many cases it can make sense to use both active and passive investments to effectively build and manage a diversified portfolio.
Definition of active and passive investing:
Active investing is an approach that seeks to capitalize on market inefficiencies by identifying individual securities that do not currently appear to be priced at their true underlying value. The success of this approach usually requires extensive research and analysis by knowledgeable investment professionals. Many traditional mutual funds fall into this category. The active fund managers who oversee these funds seek to generate returns above a benchmark or a specific measure of market performance, such as the S&P 500 Index. They make investment decisions based on an approach or a defined strategy.
On the other hand, passive investing is an approach that seeks to match the performance of a benchmark or a specific segment of the market. Many passive investors choose, for example, to put their money to work in an index fund that invests in a broad segment of the market. Perhaps the most common passive investments are funds that track the performance of the S&P 500 Index, an unmanaged index of large-cap US stocks. The principle is to hold a broad cross-section of the market, or a segment of the market, rather than trying to identify specific stocks that can outperform a benchmark or segment of the market.
It should be noted that there are more and more investment options offering a happy medium between active and passive strategies. Called strategic beta or smart beta, this investment strategy aims to combine the transparency, consistency, and profitability of passive investing with the investment insights found in active management.
Considerations for each approach:
There are pros and cons to each approach. Actively managed investment strategies offer the possibility of outperformance relative to a specific segment of the market. They can also take steps to defend against the impact of bear markets that inevitably occur from time to time, often by avoiding individual stocks or sectors that are struggling. To account for the research and expertise involved, actively managed investments typically come with higher expenses, which hurts the net returns they generate. Also, because they use a selective approach to investing, they will sometimes choose to invest in securities that do not meet expectations and may not fully benefit from broader uptrends in the market.
One of the main advantages of passive investing is that fees tend to be lower than other investment strategies. They also tend to be tax efficient as trading is minimized in the fund as it continues to track an index over the long term. A disadvantage of passive funds is that by simply investing in a benchmark index, an investor forfeits the possibility of outperforming that index. This means that returns tend to match market returns minus fees. Additionally, during periods of volatility or when markets are trending lower, index fund investors will see their investments follow a similar trajectory.
A case for both strategies:
Is one approach the best choice for your portfolio? The reality for many investors is that a combined approach can be an effective solution. Investors should pay close attention to factors that may affect their investment results, including fees, the various sources of potential investment return and the benefits of a diversified portfolio.
You may determine that part of your portfolio should generally follow the market. If so, a passive fund may make sense. At the same time, you may want to take advantage of specific opportunities in market segments where selectivity can help you achieve your goals. If so, active strategies may offer a better path to success.
The good news is that you have a tremendous opportunity to effectively diversify and tailor your portfolio to help you achieve your long-term goals. A financial advisor can work with you to determine which approach and which investments work best given your financial goals, investment time horizon and risk profile.
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Cody Sims, CRPC, AAMS, AWMA, is a financial advisor and franchise owner at Ameriprise Financial Services, LLC. in Chattanooga, Tennessee. He specializes in fee-based financial planning and asset management strategies and has been practicing for 27 years. To contact him, ameripriseadvisors.com/james.e.sims, 423-648-2900, and 412 Georgia Ave., Suite 210, Chattanooga, Tn. 37403.
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