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Integrate Active and Passive Management

How to Effectively Leverage Active and Passive Investment Strategies

02/15/2019

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One of the greatest myths in the investment world is that active and passive investment strategies are incompatible with one another. Many people believe you are either an active investor or a passive investor but you cannot be both. This couldn’t be further from the truth.
In fact, using active and passive investment strategies in tandem is an effective way to enjoy the best aspects of each investment strategy. Who says you can’t have your cake and eat it too?
In this article, we will discuss how you can leverage both active investing and passive investing strategies to reach your financial goals and manage risk. You don’t have to choose one way or the other – you can have it both ways.

What Are The Major Differences Between The Two Strategies?

Before we jump into how you can use both active and passive investment strategies in your portfolio, we want to quickly break down the basics of each strategy. Both have their pros and cons which should be understood before developing any investment plan.

Active investing is, as the name suggests, a fairly hands-on form of investing. Active investment managers look to make frequent trades to take advantage of trends in the market. These investors will buy when the market is low, sell overvalued stocks, and regularly adjust their portfolio. As a result of the regular trading, management fees for active investments tend to be higher.

On the other side of the spectrum is passive investing. Passive investors tend to take a buy and hold approach to investing. Instead of choosing specific stocks to hold, passive investors will often buy exchange-traded funds that track a specific index or sector. These funds are not designed to outperform the stock market like actively managed funds but, rather, track the market to offer steady returns. Since there is less trading activity, fees for passive investments are usually lower when compared with active investments.

Reduce Overall Costs by Leveraging Both Strategies

The fees associated with active management are one of the major downsides to choosing actively managed investments. However, a good active manager can outperform the market and make the additional fees worth it.

For people concerned about overall fees, balancing active management with passive management can be an effective strategy.

As an example, the asset-weighted average fee for passive funds in 2017 was just 0.15%. These low fees might look attractive at first but it’s important to consider the total cost of this investment.

Some people refer to this as opportunity cost. Basically, in order to save on fees you may be giving up substantial gains that an active manager could offer.

Using a passive and active strategy, investors can enjoy steady growth and low fees from their passive investments along with greater growth and higher fees from their active investments. Ideally, after the portfolio has been balanced, total cost should be lower than simply choosing active investments but total growth should be higher than if passive investments were only chosen.

Manage Risk with Active and Passive Investment Strategies

Every investment has some amount of risk associated. Even a guaranteed interest cash savings account has inflation risk. For active managers, this risk is known as the alpha. Alpha describes the ability of a certain strategy to beat the performance of the market as a whole.

A high alpha suggests that the investment manager has the ability to beat the market rather significantly. A low alpha means that the investment manager may be unable to beat the market or actually underperform the market. Obviously, alpha cannot predict the future so it is only an indication of past and current results.

Even the best investment managers will have years where they underperform the market. Investors often accept these years of underperformance in exchange for the years of potential over performance that the manager could offer.

By using passive investments as well as active management, investors can effectively reduce the risk of their total portfolio. Since passive investment tracks the market as a whole, the highs and lows of active management can be smoothed out. This may potentially lower performance in some years but also reduce the losses in down years. If charted, the ups and downs of your total portfolio would theoretically be smoother rather than extremely pronounced.

Finding the Right Balance of the Strategies

For those that want to incorporate both active and passive investment strategies, finding the right balance is important and will ultimately come down to risk tolerance and individual goals.

However, finding the right balance does not necessarily mean an even 50/50 split of passive and active investments.

One important factor to consider is the alpha of your active manager. If they have shown an ability to consistently beat the market, even after fees, then you may have greater confidence in their ability to continue this trend. If this is the case, you may want to have a heavier allocation of active investments in your overall portfolio.

Moreover, if you are looking to reduce investment risk, you may want to build a portfolio that leans more heavily to the passive investment side of things. The inclusion of active investments can offer growth potential but the potential of extreme losses could be reduced by having a heavier focus on passive investments.

Your stage of life may also dictate how you choose to balance your portfolio. As you near retirement, you may look to passive investments and reduce the overall investment manager risk of your portfolio. Young people, on the other hand, may be willing to endure greater investment risk with the potential for greater gains.

Nationally Recognized Expert Wealth Advice

Between all of the discussion of alpha, passive strategies, active strategies, fees, and financial goals, you may feel like making the right decision is difficult.

At Linden Thomas and Company, we have been recognized for offering exceptional wealth planning advice to our clients. From creating goals to building a strategy, we can help you navigate the investment landscape and build a stronger future for your family.

If you’re interested in evaluating your financial plan, contact us today.

Linden Thomas & Company

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