Understanding the Difference – and HH’s Approach to Choosing Among Them
By Brian Spinelli, CFP®, AIF®, Co-CIO
It’s rare to go for long without seeing some form of media attention around active versus passive investing. This is not a recent hot topic – it has been discussed and debated for decades. One thing I usually notice is that these articles prompt heated debate. There is an abundance of research and opinions on the subject available.
For this blog, my goal is to pare the subject down to its essentials and expand on how the terms active and passive can quickly get tangled and mean multiple things. I’ll close with a few observations on our approach to active and passive positioning in clients’ portfolios.
High-level definitions: active vs. passive investing
Most commonly, active investing is understood as the practice of selecting individual investments – not just tracking the broad markets you are participating in. Typically, the goal here is to get better returns than the investment market you are tracking. Another potential aspect of active investing is trying to control risk or loss of capital better than the broad market. On the other side of the coin, at its core, passive investing tries to replicate what a specific investment market is doing without making any individual bets against companies within that market.
Passive investing is easily spotted when someone is buying an investment that was designed to track a market. A very common example is a fund – an exchange-traded fund or mutual fund – that replicates the S&P 500 index. The sole goal of these funds is to efficiently track the index and not do anything differently. An active fund investing in the same arena that the S&P 500 Index is measuring is likely going to make decisions to deviate from the index construction and purchase positions that overweight and/or deliberately underweight certain components/stocks within that index.
Typically, passive investing is a very low cost, buy-and-hold strategy, whereas active investing usually comes at a higher cost to compensate the decision makers/managers for their skill and efforts to “beat the market,” plus factor in the increase in transaction costs.
Hopefully, this helps define at a high level what typically is meant by active versus passive investing.
Where investing gets more complicated
Now to the heated parts. A large majority of investments that are publicly available today are components of an index – likely many indexes. The indexes, or ways to measure the markets, are vast. The Dow Jones Industrial Average and S&P 500 indexes are quoted often but are not the only measurement tools out there. There are thousands of ways to slice the public investment markets and measure almost anything that is of interest. In other words, there are not just a handful of passive investment vehicles tracking a handful of market indexes.
Just as there are an abundance of ways to track different public markets, there are active managers in most of these areas who are picking securities and attempting to do better than the overall market. Proponents of passive investing argue that after the higher expense involved in active management and the large universe of historical track record data, it is very difficult for most to beat the markets consistently. This is very common to hear when discussing the U.S. stock market. Active proponents will say that you can find talented managers who are exceptional and do have a track record of beating the markets over time.
There are definitely certain markets where passive investing has supporting data on its side – that it’s not worth it for a normal investor to pursue active security selection. This is a reason why funds tracking the U.S. stock index have been so successful in attracting money. However, U.S. stocks are not the only area to invest. Diversified portfolios are going to expand into markets and areas of the world that just are not the same as the U.S. stock market.
One of the biggest areas to do this is the bond market. Bonds, globally, dwarf the size of the equity markets. There are so many different types of bonds and areas to operate in this broad market. You can replicate the indexes easily at this point and do so at a low cost. However, given the size, depth, and breadth of the bond market, there can be plentiful opportunities for active management to beat passive index funds.
Some markets just don’t lend themselves to a passive approach
While most debates you hear or read on this subject involve someone arguing for all-passive or all-active, we see it differently. We actively decide where we want to use passive investments in certain areas of the portfolios we construct, while also blending in active investing in areas we choose to pursue. In developing an investment philosophy that at its core is broad diversification across many markets and investment types, we find that not everything can be indexed appropriately. We fully support passive investing in U.S. stocks because it keeps costs low, generally is more tax efficient, and we agree this is a hard market to beat over time.
Now, start branching out into real estate, alternatives, and bonds. I’ll pick on real estate, specifically private real estate. There truly is no existing index that passively captures all things considered real estate. Also, private real estate doesn’t list on a public exchange, like stocks comprising the S&P 500 index for example. It’s in this very area we see the value of diversification for portfolios – and further, we see the need to navigate the space with active managers who know how to operate and manage physical real estate holdings. There are ways to measure if they are doing a good job, but passively replicating those measurement tools is extremely difficult and not the same thing as buying all the stocks comprising the U.S. stock market. Could you imagine how you would get a slice of all the real estate in the U.S. to passively invest in that market?
This same concept applies in the alternative investment space, where we invest money to diversify away from traditional stocks and bonds, and find sources of investment returns that are complementary to those markets. It’s in these more esoteric areas where we actively decide to use active management. One thing is for certain, markets and financial products are continuing to evolve. There may come a time where we see an opportunity to passively invest and access certain markets at a lower cost than is currently available.
For us, it’s not vs. – it’s active and passive investing
As a firm who does not create our own investment products – including mutual funds, exchange traded funds or private placements – we are not limited to having to use only active or passive in portfolio construction. Our philosophy is that both types of investing belong in most portfolios we construct. There are effective ways to bring the two different types of investing styles together to help control risk, manage a fee budget, and diversify beyond just public stocks and bonds. Investing is not a one-size-fits-all practice; many factors come into play when building a portfolio for certain individual needs and goals. So as we see it, there is a place for both active and passive investing. You don’t have to always pick the same side.
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
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