The long-standing debate between the two styles of investing- active & passive, is a rather heated one. While a majority of the investors prefer passive investing, there are numerous arguments to be made for the case of active investing. Xerxes Mullan, the Founding Partner of the global financial advisory boutique Avestar Capital believes in the merits of active investing. He believes that this hands-on approach to investing can be done right with the right expertise and a deeper analysis. “One of the key attributes of successful active management firms is the close alignment of interests between the clients and their portfolio managers”, says Xerxes Mullan.
It is important to note that active and passive styles of investing are not polar opposites but actually two ends of a spectrum. Active investing implies that you invest in funds whose portfolio managers choose investments, based on an independent evaluation of their worth. This means that they select the most attractive investments. The aim of active managers is to outperform the market or beat the market. The goal of active investing is to beat the average return of stock market’s and take advantage of short-term price fluctuations.
Passive investing on the other hand does not require the process of evaluating the value of any specific investment. Passive investing is for the long-haul and requires a buy-and-hold mentality. The goal then is to match the performance of the market indices rather than to outperform them. The goal of passive managers is to try to own all the stocks in a market index in the proportion they are held in that index. By limiting the amount of buying and selling that occurs, passive investing is a cost-effective method. Additionally, passive investing outperforms active investing owing to the lower fees that managers charge. Active investing is generally more expensive since one needs to pay research analysts and portfolio managers as well as bear the cost of frequent trading.
The case against active investing is that a majority of the active managers do not succeed in beating their benchmark each year. However, this is a flawed approach to measuring long-term investment performance. A 12 month period, although convenient, is not enough to capture the success or failure of active investing. This period may not even encompass a complete market cycle.
While numerous active equity managers do not seem to outperform the market in a year, they are able to do so over a long-term or over long investment horizons. However, in order to realize gains from active investing or to realize long-term outperformance, investors should be prepared to adopt a long-term view and be able to hold out against periods of underperformance as well. In other words, over the course of a long-term, active managers can add significant value, but the road may be rocky and investors will see some years of very good performance and some of sub-par performance.
Advocates of passive investing may wonder who might be interested in undertaking active investing. The answer is numerous individuals, foundations or pensions who’s investment periods are 20 years and beyond. Especially foundations and endowments who hope to exist in perpetuity. Defined benefit plans could also be accepting contributions from employees in their 20s for benefits that they may not receive until nearly 40 years in the future. Due to advances in the medical fields and an increase in longer lifetime spans of individuals even those in their 70s can expect to live for 20 more years.
One of the noted advantages of active investing is that it provides flexibility amidst volatile markets. Active investing lets the investor take a defensive position or hold government bonds or cash when the market is down in order to prevent major losses. Investors can also re-allocate their funds to hold more equities when the market is booming. This allows active investors to respond to real-time market conditions and thus beat the market benchmarks. Secondly, active investors can use options as a hedging strategy or even shorting stocks which can increase their likelihood to make gains and beat market indices. However, it is important to note that these strategies come with risks and costs and are best executed by those with experience or professionals. Certain experienced portfolio managers or financial advisors may even use active investing for trades that offset gains for tax savings. This process is referred to as tax-loss harvesting.
Now that the benefits of active investing have been enumerated, the next question is how you can discover active managers with the most potential to outperform the market indices. A body of research has identified 6 key attributes of active managers that can significantly help their long-term outperformance.
- High “Active Share” – As mentioned previously, active and passive investing are two ends of a spectrum and managers can be situated along this spectrum. Studies indicate that managers with high active share strategies are more likely to outperform the benchmarks. These studies also show that funds with a high active share are significantly more likely to generate returns different from the index.
- Low fees and expenses – Firms with lower fees are more likely to perform above-average whereas firms with higher fees perform below-average. This negative relationship between performance and fees occurs because in order to beat the benchmark, the portfolio managers need to beat it by enough so that after deducting fees & expenses, the net performance is still better than the benchmark.
- Low turnover – Just as low fees and expenses reduce drag on gross performance, a low turnover implies a lower level of the trading costs which will reduce net investment returns,
- Avoiding risks in the Index by considering Fundamental Value – An index fund is not risk-managed and the index fund manager has to invest in companies with a wide range of risks.. However, an active investor can avoid the securities with greatest risk and this provides risk- protection.
- Close alignment of interests – A study conducted found that those portfolio managers who are personally invested outperform their peers.
- Having a firm-wide focus on a particular core competency – A successful active management firm that focuses on specific strategies to the market shows to generate higher investor returns. Specializing in an area of focus improves the quality of information and thus results in better overall returns.
Avestar Capital is one such firm with a core competency – a focus on the entrepreneur. Xerxes Mullan and his team of portfolio managers hope to create a network that shares and builds ideas and presents opportunities for lucrative investments.