The best kept secret of investment management

By Stephen High, CPA, PFS, JD

“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” -- Mark Twain, Following the Equator: A Journey Around the World.

Much has been written about active management versus passive management approaches to investing. The active management approach attempts to time investment selections to be more heavily invested in equities when the market is rising and selling equities when the market is declining. It is also the attempt to find securities the market has either under or overvalued.

Many active portfolio managers frequently trade securities in an effort to exploit market inefficiencies or to anticipate economic trends. Frequent trading generates higher transactions costs, which reduces the fund’s returns. In addition, the short-term capital gains resulting from frequent trades have an unfavorable tax treatment when such funds are held in taxable accounts.

Furthermore, the fees associated with active management are higher than those associated with passive investment, even without frequent trading. Often mutual funds have front-end or back-end loads (commissions) that the investments get charged when funds are sold. Mutual fund sales loads may be as high as 8.5 percent. In addition, many funds have 12(b)-1 fees of up to 1 percent.

Passive management is incompatible with active management. It entails the construction of a portfolio that uses funds which are proxies for specific asset classes or markets. This strategy recognizes that it is nearly impossible to beat the market over the long-term. Investors using this approach invest in a globally-diversified portfolio of passive funds to capture the benefits offered by broad diversification.

Features of the passive management approach include lower portfolio turnover, operating expenses, and transaction costs; greater tax efficiency; a long-term perspective; broader diversification and risk reduction; periodic style drift correction (re-balancing); and incorporation of the separate dimensions of worldwide returns.

Passive investment strategies have several advantages over active strategies:

Low cost -- A passive asset class mutual fund is much less expensive to run than an active fund. Passive asset class funds do not have expensive research departments that employ large groups of analysts, as well as outside consultants. In addition, frequent trading in actively managed funds generates higher transactions costs. An actively managed fund has to add enough value to overcome the cost disadvantages.

Tax efficiency -- Passively managed mutual funds are generally more tax efficient since there is generally less turnover in the funds. Consequently, the funds generate less short and long-term capital gains distributions.

Reduced uncertainty of decision error -- Investors are exposed to market risk simply by being invested. Chasing returns in excess of those provided by the markets brings about the additional risk of selecting the wrong investments. In fact, one great disadvantage of active management is the fund manager making the wrong investment choices.

Style consistency -- Staying invested in passively managed funds provides consistency to the portfolio and allows investors to control their overall allocation by the asset classes in which they invest. Investors in actively managed funds have less control over their allocation since, by their nature, active fund managers are buying and selling in anticipation of market trends.

Better portfolio performance than most investors typically achieve -- numerous studies have shown that approximately 94 percent of a portfolio’s returns are determined by asset class selection. Most of the remainder is determined by market timing and finding “under-priced” stocks.¹

Almost all of the returns from the market come from only about 7 percent of the trading months. The other 93 percent of the months, on average, provide virtually no return. Since such a high percentage of total returns come in such short periods that are impossible to predict, the only likely way to capture all the returns is to be in the markets all the time.² A thousand dollars invested in the S&P 500 Index in January 1970 would have grown to $51,299 in December 2006 (exclusive of any expenses). If you missed the 25 best days, the Index would have grown to only $16,232, a difference of over 68 percent. The best single day was October 21, 1987, only two days after the Black Monday crash.³

A study published in the Journal of Financial Planning⁴ compared the relative performance of actively managed large- and mid-cap domestic stock mutual funds with a passive strategy during a 20-year period, including 11, 10-year rolling periods. Domestic small-cap funds could not be studied due to the small sample size. During the study periods, most actively managed funds underperformed their respective passive strategies. While every period under review had mutual funds that outperformed the passive strategy, few funds did so consistently.

Furthermore, predicting in advance which mutual funds would outperform was difficult, if not impossible, and the cost of selecting the wrong manager was high. Many of the actively managed funds did not survive the study periods. These factors combined demonstrate the difficulty for financial advisors to select superior performance. Given the evidence, why would you speculate with your money using active management? Designing and adhering to a passive investment strategy that addresses your long-term financial goals and your ability, need and willingness to take risk is a prudent approach that can serve you well through good times and bad.

Stephen High, CPA, PFS, JD, is the chief manager of Kraft Asset Management, LLC, a fee-only registered investment advisory firm affiliated with Nashville-based KraftCPAs PLLC.

¹ Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July-August 1986, pp. 39-44; and Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, “Revisiting Determinants of Portfolio Performance: An Update,” 1990 Working Paper.
² Larry Swedroe, The Successful Investor Today: 14 Simple Truths You Must Know When You Invest, Appendix B, page 263
³ The S&P data provided by Standard & Poor’s Index Services Group
⁴ Thomas P. McGuigan, CFP®, “The Difficulty of Selecting Superior Mutual Fund Performance”, Journal of Financial Planning, 2006 February Issue

This article, which appeared in the April 2008 issue of Nashville Medical News, was reprinted with permission.