Active vs. Passive Investing Debate

An observation on active vs. passive investing, it’s affects on the portfolio and the risks involved.

Equities

I’m a bit of an old war horse when it comes to managing money.  I began in the financial services industry in the early 1980’s, long before passive investing became common nomenclature.  I have observed with interest the morphing of investment strategy from actively managed mutual funds to one of owning passive indexes.  It is true that passive investing can be less expensive than using an active manager, but I question whether it is better.

Active vs. Passive Investing

Risk

The active / passive debate often focuses on equity returns vs. a benchmark.  Risk is rarely ever mentioned and it matters, especially when prices are falling.  Which would you rather own, a fund that that earns 10% with a beta of 1.0 or one that earns 9.8% with a beta of .9?  Personally I would rather have a bit less return with a lot less risk.  The manager earning just under the passive index with less risk would be considered to have underperformed by the statistics used to determine performance percentages.  Risk matters and active managers can and do adjust the risk of portfolios based on their perception of the amount of risk in the market place.

International vs. US based investing

I often see statistics stating the average active manager fails to beat a US index.  What about international funds?  I have yet to find a study that focuses on the management of foreign funds.  This is significant because foreign markets, especially emerging markets, are perceived to be less efficient than US markets.  Being less efficient can be due in part, to differences in accounting rules and the overall amount of data available.  Less efficient markets offer opportunities to the active manager that is on the hunt for good ideas.  Risk in foreign markets is especially important for investors to consider when deciding between using an active manager and a passive index.  I would gladly accept returns slightly under the passive benchmark in the international investment category if the risk was materially lower.

Income Investments