Sunday, January 15, 2012

Combining Active and Passive Investment Strategies

As part of my Continuing Education Requirements to maintain my CFP (R) Designation, I recently read a publication called Strategic Index Investing offered by Beacon Hill Financial Educators. Though it was originally published years ago - and though it discusses many very familiar investment methods and components - it recommends a facsinating overall investment strategy.

Active VERSUS Passive
I thought I had exhausted the information available on common investment strategies, many of which seem to be directly at odds with one another:
  • Modern portfolio theory and strategic asset allocation versus betting on different industries and sectors;

  • Active versus passive investment vehicles;

  • Attempting to time the market versus buying and holding.

Almost everything I've previously encountered argues either for or against active managment techniques, but this book condones the implementation of some active strategies while still agreeing that passive investing is the way to go.

The basis of the argument and about half the book is spent showing how Exchange Traded Funds - specifically Exchange Traded Index Funds - are the best possible investment vehicle for individual investors. I outlined a few of the reasons in my last post.

The author agrees with many Bogleheads who firmly believe - based on much cited evidence - that investing in indexes which track the market or certain sectors of the market is a better way to go than investing in actively managed funds. And by "better" of course I mean that index investing is cheaper, more tax efficient, and statistically much more likely to provide investors with a higher return.

Most authors who espouse index investing also emphasize the importance of a Buy & Hold investment strategy and caution endlessly about the futility of trying to "time the market." It's as though the only two options are to buy index funds and ignore your portfolio for a few decades or become a caffeine-crazed day trader who is chained to his laptop making dozens of impulsive trades each week or month.

Passive PLUS Active
This publication opened my eyes to the possibility of rationally combining passive investment vehicles with relatively active investment management.

The author does believe that passive investment vehicles are best, that setting and sticking to an appropriate asset allocation is imperative, and that the market generally increases in value over time and so buying and holding investments for the long term is ideal. HOWEVER he also endorsed and explained several active investment strategies such as:
  • Tactical Asset Allocation (making small temporarty changes to a strategic asset allocation to over/under weight various asset classes or styles in an attempt to enhance overall return)

  • Core-satellite portfolio construction (where the "core" of the portfolio remains in passive investments according to the strategic asset allocation but 10-30% of the portfolio is comprised of "satellites" which may emphasize specific industries or geographies or be invested actively).

One active investment alternative which may be used in the satellite portion of the portfolio include the buying and/or selling of options, which the author spent some time explaining. Options are not necessarily any more risky than owning a security, and they may even be used as an insurance policy to decrease the risk (and return) of owning a particular stock or ETF.

These active strategies are all recommended as a way to attempt to enhance the returns earned through a primarily passively invested buy and hold portfolio; they are not endorsed as an alternative to passive investing. That's the key difference.

Benefits and Additional Considerations
There are situations in which these active management techniques can be appropriate. What if you want to take advantage of The January Effect or you work in an industry you believe is really about to be hit hard - or take off - and you want to edge toward or away from it? Perhaps you make your career as a banker and simply want to ovoid over-exposure to that industry by shorting or underweighting some financial ETFs. These active strategies allow you to make adjustments WITHIN the framework of a comprehensive investment plan.

Investors who simply invest in a broad market index fund and refuse to allow themselves to tweak their portfolios often end up getting to the point where they feel forced to move all their money either into or out of the market in huge waves (usually at the worst possible times), since they don't have a mechanism with which to tweak their 'all or none' investment approach.

Active management isn't for everyone of course - it does require some skill, some ongoing education, and some monitoring efforts. Important considerations when actively investing a satellite portion of your portfolio include creating an effective exit strategy, something that obviously does not come naturally to us classic buy and hold investors (this should include the use of Stop Loss orders so you aren't chained to your "sell" button or to CNBC). Another new skill that active investors must aquire is ongoing monitoring and evaluation.

Buy & Hold is the method chosen by most not because they believe it's the best way to prosper but rather because it requires zero effort. But you can still attempt to enhance return while keeping a total "hands off" stance; your "satellite" might be the portion of your portfolio you hand over to a professional to actively manage.

I don't know about you, but this all makes a lot of sense to me. I think most of us who may believe in indexing and buying and holding are also tempted to tweak our investments from time to time - to bet on certain industries or weight a certain asset class that's been underperforming for years. It's comforting to know that doing so can be a part of one's overall investment strategy - it doesn't have to be some heresy you do in secrety on the side.

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