Forex Articles

Those investors who are getting close to retirement age may want to review their portfolios to determine whether the investments they are holding are appropriate. One aspect of their portfolios investors want to consider is whether it is better to hold passive or active investments into retirement. There are advantages and disadvantages to both investment types. Passively managed investments often have lower fees. Active managers must justify the extra expense for managing investments. On the other hand, actively managed investments may have better risk management, especially for either bond funds or funds targeting low-volatility returns. The unique financial situation for each investor approaching retirement is also important. The size of the portfolio and the risk tolerance of the individual investor dictate the type of investments to make.

Passive funds have quickly been gaining popularity. In 2014, passive funds had capital inflows of $166 billion, while active equity funds saw outflows of $98.4 billion. Clearly, many investors see the advantages of passive investing. However, certain investors, including those with larger portfolios, may want to consider allocations to actively managed funds.

Passive investing refers to a type of investment management where the mutual funds or exchange-traded funds (ETFs) mirror the performance of a market index. This is the exact opposite of active management where the fund manager attempts to actively beat the performance of the overall market.

Those who subscribe to the efficient market hypothesis (EMH) want to invest in passively managed mutual funds and ETFs. The EMH holds that the market accurately reflects all available news and information. The market is able to quickly absorb new information, which is reflected by appropriate adjustments to stock prices. It is impossible to beat the overall market returns due to the efficiency of the market. As such, it does not make sense to attempt to beat the market. Rather, gaining mere exposure to a market that generally trends upward over time is the best approach.

There are a number of advantages to passive investing. The main advantage is low expense ratios and fees. Passive investment vehicles need to merely replicate the performance of the index they are tracking. This generally results in a low turnover, low trading costs and low management expenses. For example, a mutual fund or ETF that tracks the S&P 500 may have an expense ratio of only 0.2%. An active equity mutual fund can easily have an expense ratio in excess of 1.0%. Over a period of time, that 0.80% can significantly change the performance of an investment.

Another major advantage for passive investments is transparency. It is easy to know what a fund is holding at all times. While the holdings of an actively managed fund or ETF may change quite often, passive investments have greater predictability. This can allow investors to make more informed decisions. For example, if an investor is concerned about volatility in a certain part of the market, he can easily ascertain his exposure to that area. However, with an actively managed investment, it is more difficult to know exactly what a fund is holding.

The impact of taxes is also another distinct advantage of passive investments. Since index funds are not turning over their holdings very often, there is no triggering of large capital gains taxes. With an active fund, the higher turnover can result in capital gains taxes for the year. This may catch investors off guard if they are not expecting a tax bill.

There are definite downsides to passive investments. A major risk is the possibility of a large market decline. The S&P 500 declined around 36% in 2008. The value of index funds tracking the S&P 500 saw major losses. An active manager might be savvy enough to perform some hedging or limit market exposure during periods of higher volatility. This can reduce the drawdown for an investment.

Another disadvantage for passive investments is the lack of control of the component investments in the index. For example, the high-yield bond market has experienced significant volatility during the latter half of 2015. One reason for the volatility is continuing low commodity prices that have hurt smaller oil and gas companies. Smaller oil and gas companies often finance their operations and expansions by issuing lower-quality debt. An investor who holds index funds tracking high-yield bonds has significant exposure to this sector of the high-yield market. The only way for the investor to limit this exposure is to exit the position. In the alternative, if the investor is bullish on certain bonds in the high-yield sector, he is stuck with the holdings in the index.

The negatives of passive investing highlight some of the positives of active investing. Actively managed investments can try and reduce exposure during periods of high volatility, while passive investments merely track the market. Active managers can use hedging strategies such as options or selling stocks short to try and profit in downward moving markets. In the alternative, active managers may reduce or completely exit certain sectors when volatility increases. Active managers have flexibility as opposed to passive investments.

Further, active investments can try and beat the returns of the market, leading to the possibility for outsized gains. Passive investments only provide average performance. However, this is based on the performance of the manager. Consistent managers with good returns often come with higher expenses. Further, there is no guarantee the past performance for an active fund will continue into the future.

As a practical matter, investors with larger portfolios are in a better position to allocate a portion of their assets to active investments while still getting exposure to passive indexes. These investors may want to shoot for outsized investment gains, and they generally have access to better financial advice. However, smaller investors need not fret. Even Warren Buffett has advised his estate to put 90% of his assets in a low-cost index fund that tracks the S&P 500. If this approach is good enough for Buffett, it should serve most investors well.