When it comes to finding the best investment strategy, there’s no one right answer.
In just the past decade, the investment management industry has undergone substantial change.
With the emergence of exchange-traded funds (ETFs), passive index strategies have gained tremendous popularity among retail investors, and for good reason. ETFs offer an inexpensive way to gain broad exposure to entire markets that otherwise would not have been feasible in the past.
As the popularity of indexed ETFs has risen, so has the prevalence of “set it and forget it” passive investing strategies. This low-cost, low-maintenance strategy has sparked a paradigm shift in the investment community. Many are now taking a hard look at the merits of active investing.
What has been the status quo for decades is now being challenged.
My goal is to find what I think is the best approach for the average investor.
Instead of tackling this issue with the end goal of picking one strategy over the other, I’ve identified benefits of each strategy (active and passive) and constructed a framework that incorporates aspects of each.
In this post, I propose a methodology for the individual investor to construct a portfolio that is composed of both active and passive allocations. This non-conventional process looks at risk not only from a traditional asset allocation perspective but also from an active/passive allocation perspective. It overlays the two to create a comprehensive portfolio allocation.
How and Where to Invest: Framing the Debate
Let’s step back for a minute and look at why the stock market exists in the first place.
The stock market is the backbone of modern capitalism as we know it. Its purpose is to efficiently allocate capital to companies that investors perceive as having the most growth potential.
So how does that relate to capitalism?
Over time, this repeated process of putting money towards its most efficient uses spurs innovation and overall output and ultimately improves the standard of living for a society.
As it turns out, stocks behave just like any other good: if demand for a stock increases because investors feel the future of a company is bright, the price per share will increase, too.
Higher demand=higher price.
The same concept applies to struggling companies: a stock will decline as selling pressure outweighs buying pressure.
Lower demand=lower price.
So, every day, we have this ebb and flow of supply and demand taking place for every stock in the world (there are thousands). Some stocks end the day higher than they started, some end the day lower.
The most successful investors are the ones that can correctly pick which stocks will go up in value over time. Easier said than done, though.
This is the central concept of active investing. Out of the total universe of stocks available for an investor to purchase, they only invest in a select number of companies — the ones they think will increase in value.
(Am I boring you yet? Last chance to jump over to the light version!)
So how do active investors choose the best investment strategy?
Long story short, there are hundreds of different strategies out there.
Active investors usually start their research by identifying the specific strengths and weaknesses of a company.
Then they might look at how these companies are positioned against their competitors, as well as the overall health and future of the sector the company is in. They’re likely to dive into the financials, and might even run some forecasting models based on the data they find.
If this sounds like a time-intensive investment strategy to you, you’re right.
This level of research takes a considerable amount of time, effort, and skill, BUT it comes with the possibility of picking stocks that will outperform the stock market as a whole.
This outperformance is what’s known in the industry as alpha. (There’s a crazy amount of jargon in the finance world, in case you hadn’t noticed yet).
Finding stocks with the potential to generate alpha requires a substantial amount of expertise — not just any Joe Schmo can fire up his laptop and go to town on some in-depth stock research. It just doesn’t work that way.
The problem is, those that do possess that skill tend to command a hefty fee for their services.
Investment managers typically charge fees as an annual percentage of the assets they are managing. For instance, a mutual fund manager may charge a 1% annual fee as compensation for performing research and executing trades for the fund. On a $1M investment, such a manager would charge $10,000 per year to manage the assets.
Active management is not cheap, especially when there’s no guarantee that the manager will beat the market, let alone even generate a positive return at all on the investments.
So if the fees are high and there’s no promise that paying them will lead to higher returns, what’s the alternative for investors?
The Rise of Passive Investing
There’s research suggesting that, after fees, it’s nearly impossible for a manager to consistently outperform the overall market. With the cost of management being so high, a lot of individual investors have turned their attention to index funds, which charge razor-thin fees.
An indexed ETF or mutual fund, instead of attempting to sift through hundreds or even thousands of stocks to find potential winners, takes a totally different approach.
Index funds buy and hold every single company in the index they are tracking.
An S&P 500 index fund, for example, will hold shares of stock from all five hundred companies in the index, usually weighted by market cap (meaning that the amount of shares purchased of a specific company is proportional to the company’s size).
Since there is no skill involved in casting a big net and picking every single company in an index, management fees for these types of funds are substantially lower than actively managed funds. The Vanguard Total Stock Market ETF (Symbol: VTI), one of the most popular index funds on the market, charges a razor-thin 0.05% yearly fee.
Using passive index funds like these embodies a totally different investment philosophy than the traditional approach of active investing (putting money into specific companies you think will do well — or paying someone else to).
By putting money into an index fund, investors are essentially saying “Hey, I don’t think it’s possible for a money manager to generate alpha, after fees. And I definitely can’t do it on my own.”
They have instead decided to “take what the market gives them,” and save more of their money from being eaten up by expensive management fees.
Which is the Best Investment Strategy?
Both passive and active investing strategies have their drawbacks.
The big problem with active management is rooted in fees.
Managers simply charge too much for the value they are delivering (and in many/most cases, no value is being delivered at all), and most retail investors are not equipped to manage their portfolio without guidance.
Over time, the annual management fees take a significant chunk out of investment returns. Remember, compounding works both ways; taking an annual percentage out of a growing number really adds up.
That’s real money being eaten up by fees.
Think about what you could do with that extra money. That’s college tuition, your dream car, a higher standard of living in retirement — just from savings in fees.
Check out the graph below which shows the example I just described:
Now, for some people, the price paid to an investment manager is justified. It can be much easier to sleep at night with the peace of mind knowing that you don’t need to worry about constantly watching your portfolio.
If you’re lucky enough to find a manager that can consistently deliver solid returns, then obviously their fees can be justified to some extent, especially if they are providing other financial planning services to you. As already mentioned though, this is very hard to come by.
Another Problem With Active Management
The other issue with active management, besides the crippling long-term effect that the fees have, is the risk of material underperformance relative to the rest of the market.
Since an active manager is making targeted trade decisions, if he or she picks a few big losers, the portfolio could take quite a hit, even if the market is up. So often it happens that the market will be up, say, 10% in a year, but a client only realizes 5% or so in returns (and remember, that investment manager is still getting paid his 1% no matter what!).
It’s usually after this happens that most sane investors will ask themselves “Why didn’t I just put my money into an index fund?? I would have had better performance AND paid way less in fees”.
It’s a legitimate question and one that many financial advisors and investment managers have had to scramble to answer.
The Big Issue With Passive Investing
As it turns out, though, not everything is rosy and wonderful in the passive index fund camp, either. The argument against strictly using index funds to build a portfolio is more philosophical in nature, but it’s still worth working through mentally.
This video does a really good job of describing what’s wrong with passive investing (note: I have no affiliation with Wintergreen, and yes they are an active management firm with high fees. Nonetheless, this guy makes some good points.):
When an investor chooses to invest money into an index fund, it represents a seismic shift in mentality and actually goes completely against how equity markets were meant to function.
Once an investor buys shares of an index fund, they are willfully allocating their capital without any regard for the underlying intrinsic value of the companies in which they are investing. That was a dense sentence, so go back and read it again to make sure you got it all.
By simply purchasing shares of every company in an index in proportion to their weight in that index (again, most indexes are market cap weighted), the larger companies are, by default, purchased more. Since more buying is directed towards the big names in an index, valuations can (and will) become artificially inflated in a rising market.
The real-world economic purpose of markets is to provide efficient allocation of resources for a society.
When resources are optimally allocated, this results in a growth of business and wealth for an economy as a whole. However, this efficient allocation is critically dependent on the daily interactions and decisions of millions of investors in the marketplace who are acting based on their opinions of the value of publicly traded companies.
The Social and Economic Impact of Passive Investing
Buying an index fund undermines the way capital markets are meant to function and could have significant social and economic consequences if investors continue to pile into them at the rate they are today. Index funds are purchasing stock of America’s biggest companies without regard for valuation, future growth prospects, quality of management, or any other factors that should influence an investment decision.
These funds are gaining massive popularity, as there are now trillions of investors’ dollars committed to them. In 2014 alone, $167 billion was added to passive equity funds. That brought the total assets under management for index funds, or AUM, to about $2.2 trillion.
Think about that for a minute: $2.2 TRILLION, more than 12% of our national debt, has been invested into the stock of companies in a mechanistic process simply based on their inclusion in a stock index, and not based on the perceived under or over value of share prices.
A lot of passive funds are being pitched at lower risk to investors since they are so diversified in the sheer number of stocks they own.
It’s easy for the naïve individual investor to fall for the allure of dirt cheap expense ratios and the idea of being more protected from risk, but the reality is that these index funds are not as safe as they may appear.
Something to keep in mind as the investing world is contemplating (and even embracing) this shift towards index funds is the overall stock market environment that has predominated during the discussion.
As of this writing, the stock market has welcomed one of the strongest bull markets in recent history. As such, being invested in an index such as the S&P 500 would have paid off handsomely for someone who was invested at the beginning of the ascent, and recent data suggests that the S&P has in fact outperformed many active money managers.
Take a closer look, though, at what exactly drove the S&P’s performance in 2014:
In 2014, the top 25 best-performing stocks (top 5% of the index) in the S&P 500 accounted for 55% of the total return of the index, leaving the other 95% of the companies contributing only 45% of total returns.
Microsoft, Apple, Intel, and Facebook accounted for over 20% of returns just by themselves.
While great on the upside, think about what will happen when the party ends. A lot of passive investors will be hurting.
Index funds conceal a huge concentration of risk for investors that may be under the false impression their returns are determined by an equal sea of hundreds of stocks that they own.
Using a passive index fund should be viewed as a play on equities as an asset class, with a bias towards large cap companies. Understanding that is so important.
It should also not be considered a coincidence that the meteoric rise of indexation as a viable long-term strategy has taken hold during a continually rising market.
How to Create the Best Investment Strategy
Despite the drawbacks of each investment approach, I do think there is a way to blend the two strategies to create a cost-effective, risk-managed portfolio.
When done in a responsible and sensible way, investing can be a very powerful activity that truly does have the potential to change someone’s life for the better. However, mistakes made in investing can also have the power to negatively impact your circumstances drastically if you are not careful.
1. Choose your risk tolerance
Before jumping into a proposed method of combining active and passive strategies to build a portfolio, I want to briefly address the idea of risk tolerance.
To have any chance of acting rationally in a market that can be quite volatile at times, you need to make sure that you are investing money that you are totally comfortable with losing.
This sounds counter-intuitive since the whole point of investing your money is to generate a positive return. Everybody knows that there is risk involved when it comes to investing, but very few truly realize what that means until it’s too late.
This is one of the most misunderstood concepts in personal finance: individual investors do not fully grasp the amount of risk they are taking when they decide to invest their nest egg in the stock market.
Just ask any financial advisor and they will all tell you the same thing…
… something along the lines of “pay off your debts, save up an emergency fund, and invest the rest.” For a lot of investors, “the rest” is a significant amount of money, and just because it’s there does not mean that it needs to be invested in something as risky as the market.
Having a lot of cash on the sidelines is by no means a bad thing, and for those who say you’ll lose to inflation- don’t listen to them. You’ll lose even more if you make bad decisions that are fueled by discomfort.
Investing in today’s market should be something that you do with clear purpose and intent; it should not simply be the default place to park extra savings.
This is what I think is the root cause of most irrational investor behavior. The money just means too much to you. In order to behave optimally in an emotionally driven market, those who succeed are the ones who have total emotional detachment from the money. Easier said than done.
So, with the money that you do decide to invest, coming up with an overall asset allocation is the next step. There are plenty of free resources out there to help you determine a recommended stock and bond allocation based on your investment goals, time horizon, risk tolerance, and so on, so I’m not going to cover it here.
If you need help, Vanguard’s website has a great free resource for building an asset allocation.
Financial advisors usually charge a steep fee for this service, but it’s nothing that you can’t do yourself with just a little bit of research. Really.
Looking for a good online investment broker? I recommend Ally Invest – very easy to use with a bunch of awesome tools to help you manage your portfolio. Get $100 in free trade commissions by using our special link.
2. Determining your passive and active allocations
After you have determined your risk allocation from an asset class perspective and are comfortable with the amount of money you are investing (remember, having a lot of cash on the sidelines can do a lot for your mental well-being; it’s really not a bad thing), the next step is to decide how much of your portfolio will be invested in low-cost passive funds and how much will be actively managed.
The first question you should ask yourself is “how much time am I willing to put into managing the active portion of my portfolio?”
Even if you are paying a flat fee for third-party research (which is what I would recommend, as opposed to paying an annual percentage of assets), you should absolutely still do your own due diligence before buying or selling any securities.
Obviously, if you are not able to make at least a modest commitment (I’m talking a few hours a month), your actively managed allocation should be lower. This is just common sense; you should not be heavily invested in things that you which you yourself can’t keep up to date on. After all, the money is yours- no one else’s.
Since the goal of active investing is to generate alpha (index-beating returns), it makes sense to actively manage the asset classes in your portfolio that have the highest potential for outperformance. Therefore, a good rule of thumb is to focus active efforts on the equity portion, as opposed to the bond allocation of your portfolio. Bonds are generally less risky than stocks (and therefore offer less potential reward), so it makes more sense to just use low-cost passive funds for your bonds.
Which Equities Should You Actively Manage?
Within the equity portion of your portfolio, using market-cap weighted index funds for your large-cap stock allocation is a smart choice.
You will still achieve broad market exposure to an extent. Besides, most actively managed large-cap funds are commoditized these days- they all contain pretty much the same stocks. Just buy your index fund here and call it a day.
This leaves you with mid and small-cap stocks to target your active management on.
This is where I think you’re likely to get the most bang for your buck, on a risk-reward basis. These are the companies also most likely to be mispriced in the marketplace, simply by virtue of the fact that smaller companies get less coverage by Wall St. and the media. With fewer investors participating in the buying and selling of a company’s stock, the chances are higher of share prices diverging from their intrinsic value.
This divergence, if correctly spotted, can and should be exploited for a profit. This is the whole reason why we invest- to take advantage of perceived mispricing of securities.
Hitting a few home runs here can really boost the performance of a portfolio, especially if you aren’t stuck paying crippling annual management fees to a portfolio manager or financial advisor.
An Alternative to Traditional Active Management
As highlighted earlier, paying for active management in the traditional sense should not be considered a viable option for the average individual.
The fees associated with actively managed mutual funds and ETFs (which, remember, are in addition to the yearly fees you pay to your financial advisor, if you have one) are too detrimental to a portfolio over the long term, especially when you consider that there is no guarantee a manager will even beat their benchmark, after fees.
By paying high fees, your portfolio is swimming against a current that it shouldn’t have to.
In order to avoid paying fees, an individual investor needs to manage their portfolio themselves.
However, the simple truth is that most non-professional investors lack the research skills, market understanding, and behavioral control to be able to responsibly manage their own portfolio without some form of help. When left to their own devices, research suggests that many individuals will inevitably make choices that seriously harm their portfolio over the long term.
The good news is that there is a middle ground between paying huge management fees to an advisor and managing your own portfolio with no guidance at all (and no fees). The answer is to pay a flat fee for research done by professionals and use that research as a primary source for investment ideas in your portfolio.
Once your portfolio is above a certain threshold size, the flat fee model is by far the best value, as long as you are willing to make a small time commitment to actually reading the research and making your own trades (using a low-cost online discount broker).
There are many companies that provide investment research services for a flat fee, some better than others. When deciding on whose research you want to purchase, there are a couple things to keep in mind:
- Do they have a track record of decent returns that can be verified?
- Are their returns too good? Be careful- many companies will fudge their numbers to look good.
- Does their research fit what you are looking for?
3. Choose an option with low fees
I want you to know that, with a modest commitment to learning, and maybe a little bit of help with research, investing can be done in a responsible and cost-effective way. You can make a lot of money through investing, and it really can change your life for the better.
The investment industry is going through a major transformation right now. Individual investors are beginning to see the light and acknowledging that active management, in the traditional sense, is a sham.
The only ones guaranteed to make any money in active management are the managers themselves, certainly not their clients. As a result, many investors are piling in droves into passive funds perhaps without a full understanding of what that could mean for them and their portfolio.
It’s time for investors to take a fresh look at their options for portfolio management, and the most viable option for investors that aren’t skilled enough yet to do their own research, in my opinion, is to use research done by professionals for a fraction of the cost of hiring a traditional money manager.
- The Lazy Way To Make Money Investing – Earn Passive Income While Sleeping
- How to Start Investing: A Guide to Investing for Beginners
This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer to buy or sell any securities. This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. No visitor should make any investment decisions without first conducting his or her own research and due diligence. Commentary, analysis, opinions, advice, and recommendations represent the personal and subjective views of the editor. Since Breaking The One Percent and VTX Capital, LLC are impersonal and do not provide individualized advice for specific visitors, the editor can only answer questions of a general nature about the markets or specific funds.