Updated: Aug 25, 2021
Active, Passive, or Sales Pitch? The GWS Stance on Active vs. Passive
The efficacy of active vs. passive investing is one of the oldest debates in the books. But it’s not that simple — and, often, these terms are just used as part of a sales pitch. At Gatewood Wealth Solutions, we are neither active nor passive; we are agnostic. Instead, we use strategies we discern that are better for our clients based on their specific situations and goals.
Why isn’t this as simple as it sounds? Think about it: we’ve all heard people say, “I’m a passive investor.” But what do they mean by that?
No One Is Truly “Passive” When It Comes to Investing
If you mean, you’re not doing much, that makes a lot of sense. Passive investing is a set-it-and-forget-it type of strategy. But what is typically represented by having a “passive strategy” is that you have no opinion on different markets — that everything will average out over time, and the time and cost of underwriting that is not going to bear any fruit. Like any strategy that gets market exposure, it will work at the end of the day! And there is nothing wrong with it. You, at a minimum, will get the market minus fees; you may just not get the best performance.
Even then, everyone has a different “passive strategy.” For example, let’s say you decide just to buy an index — the S&P 500 — as your “passive strategy.” Already, you’re saying, “I believe these U.S. large-cap companies are my best investment option, so why would I buy anything else?” You have an opinion and are taking an active tilt.
Plus, with a strictly S&P 500 portfolio, about 25% of your holdings are going to be in just a handful of stocks. So your portfolio is going to be dominated by Apple, Microsoft, Google, and other big names that may or may not form the concentration that you want. And, in a rising rate environment, those technology stocks could drastically underperform the rest of the stocks in the S&P.
This strategy also begs the question: is index-buying genuinely passive? Suppose you’re employing a truly passive strategy. In that case, you should have a market-weighted approach — meaning you’re taking into account the percentage of Apple, for example, versus all the other investments out there. Under that methodology, you would have a minimal position in Apple, emerging markets, international markets, available commodities, precious metals, private equity, venture capital, and bonds. So, no one truly is a passive investor.
The Paradox of Passive
If markets are reasonably efficient, it’s not necessarily wrong to passively invest — meaning you’re not going to pay for the underwriting and due diligence. But then you have the paradox of passive investing: If the market is efficient, meaning stocks are rationally priced and trading at a fair price given all known information, where are we getting that information? Active investors. They’re the ones behind the scenes trying to move the stocks to do the rational thing. If everyone were to invest passively, active investors would have a bonanza to do due diligence.
Given this paradox, we see cycles of active vs. passive being popular strategies. At first, there may be a surplus of active managers since there’s so much excess return through underwriting. Once stocks get to more efficient prices, though, there will be fewer excess returns, meaning stocks will start to underperform the benchmark. At that point, more capital will flow back to passive strategies, and there will be more movement in stock prices that are no longer efficient.
Knowing this cyclical nature of active vs. passive trends, we build these cycles into our portfolios. We use active managers at some times and passive at others if we’re in a period where there’s a better opportunity to maintain the market.
Again, because of how we view the active vs. passive debate, we’re agnostic. We’ll use ETFs if they have a basket of stocks that we want at a meager cost on the internal management fee vs. a mutual fund. We approach our fund decisions with the mindset of, “What basket of stocks — whether it’s an ETF or active manager — are working well? Which help us get to where we want to go?”
Digging into the Data
Whatever is doing well is doing well for a reason — and is likely to keep doing well until there is some type of narrative change. That’s why we monitor performance so closely.
We believe an agnostic strategy is still an excellent approach to management, despite what looks to be a very efficient market. The benchmark typically ends up in the second quartile, so some funds are doing slightly above average.
Then, if we look at the three, five, and ten-year, there’s a lot of consistency in what was doing well in 2017 and what continued to do well going forward. There’s a sleight of hand used in our industry about a passive approach and the assumption that you can’t outperform the market in the long term. We see 25% of the companies are consistently in that top quartile, and we haven’t come across the page where the benchmark is in that top quartile.
Again, whatever is performing well will maintain momentum until there is a change in narrative. The main point is the sectors that do well will continue to do well — and if you over-allocated those sectors, you would have been in the top quartile of those funds.
Everyone is doing a form of active management. We all have some type of opinion; no one is buying a proper passive portfolio. We are happy to provide you with more performance data to further demonstrate our portfolios’ efficacy; just contact your advisor.
Of course, there is no right or wrong when choosing a path to invest in, but at GWS, we try to give you our data-driven view of economic theory. Our goal is to dig deeply into market behavior to inform you better to make actionable decisions to achieve your goals.
To learn more about active and passive investing, be sure to listen to our recap video on our YouTube channel and SUBSCRIBE!
For detailed performance metrics, please don’t hesitate to contact your lead advisor. And, in the meantime, be sure to keep up to date on Gatewood Wealth Solutions through our daily 3x3s and our weekly market insights on our YouTube, LinkedIn, and Facebook accounts.
Economic forecasts may not develop as predicted, and there can be no guarantee that strategies promoted will be successful. Therefore, the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All performance references are historical and are no guarantee of future results. In addition, all indices are unmanaged and may not be invested directly.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. All investing involves risk, including possible loss of principal. No strategy assures success or protects against loss.
The opinions in this material do not necessarily reflect the views of LPL Financial.