Tuesday, May 17, 2011

Passive vs Active Portfolio Strategies: Which do you use?

How do you know if a "passive" strategy is what you want or need?.....and what exactly is a passive strategy?.....and how do Exchange Traded Products (ETP), such as ETF Index funds fit into a strategy?

Exchange traded products, for our purposes, will include exchange traded funds (ETF) and exchange traded notes (ETN). Both of these products are an effort to reflect the performance of a chosen index as a general rule. Notes will typically use debt instruments (forward contracts) to obtain the index returns while funds generally hold the underlying securities (stocks or bonds) from the index to accomplish the same results. The blog will talk about ETFs, however in most instances you can use ETNs to accomplish the same goals.

ETF’s have changed the game when it comes to investing regardless of whether you are a professional or an individual investor. The goal of serious investors is to: diversify risk, make a positive return, and to keep as much of the return as possible. Professionals generally try to “beat” an index while most individuals aim for a reasonable after tax “total return” relative to the market indexes.
One of the challenges of being an individual investor is the difficulty in understanding which strategies are for “professional investors” and which ones are for “retail or DIY” investors. I want to start with a couple of broad statements to set the stage for how this blog will approach the strategies:

1-      Individuals who “think” they are experts will often take on high risk strategies and often confuse luck with skill. If you “play” the markets, use your “instinct” to tell you when to buy or sell, or feel you have the ability to determine the “sector rotation” timing or market momentum at any given time, then please feel free to skip this section (and perhaps this whole blog) as you won’t accept what I have to say. If you believe a well balanced broadly diversified portfolio can help you share in market gains then please read on.
2-      The terms “passive” and “active” are often utilized when discussing ETF Index Funds and Mutual Funds. The term “passive” can be used to reflect both a type of “security” and an investment “strategy”. Thus an index fund that has a strategy of mirroring a chosen index will be called a “passive” security. An investor who, in turn, tries to hold a diversified strategic allocation of passive funds will be said to have a “passive” strategy. Conversely, an investor who attempts to buy and sell securities in an effort to outperform markets will be considered to have an “active” strategy. If the investor holds funds that also attempt to beat the benchmark indices, the funds will be  deemed an “active” security. As you will have rightly assumed, "passive" means a hands-off approach while "active" means on-going trading of investments.

So, what does that mean? Well, it suggests we can have 4 different scenarios:
1-      Passive Security and Passive Strategy
2-      Passive Security and Active Strategy
3-      Active Security and No Strategy
4-      Active Security and Active Strategy

Passive/Passive:This is what I will call the “true” indexing strategy and is the only strategy this blog site recommends for Do-it-Yourself investors. This approach requires an investor to determine the strategic asset allocation model they wish to maintain, and then to fill that allocation with passive index funds. As an example, a 3 asset class model with 3 equity sub-classes can be utilized to create a great allocation model using 5 passive index funds.
The 3 asset classes are:
 A-Cash – short term low risk debt securities maturing in less than one year, bank account
B- Fixed Income- Interest bearing debt securities maturing in one year or more (1-30 years typically)
C- Equities – individual funds or securities in “stocks” whether common or preferred
Equities sub-classes: Within the equity class we might further break down the holdings into three geographic sectors: Domestic, U.S., and International
In this scenario a simple “passive/passive” portfolio might include 5 securities:
1-       a money market fund
2-      An ETF reflecting the Dex Canadian Bond Universe
3-      Three equity ETF Indexes reflecting – the TSX 500, the S&P 500, and the EAFE index
The joy of this type of investing is that it is easy to understand, easy to implement, and easy to monitor. Investors have some research to do as they need to decide which broad based index they wish to follow i.e. the S&P 500 versus the Russell 3000 or the Dow Jones Industrial Average, but the basic concept is the same.

A number of professional investment managers are utilizing passive securities to implement an active strategy. The primary reason is that index funds allow an investment manager, using a single trade, to enter or exit from an asset class or sub-class. As an example, if the previously shown model was utilized by an active manager, trading the ETF Index fund representing the TSX 500 allows the manager to completely enter  (buy) or exit (sell) the primary Canadian stock market. This easy approach to making significant portfolio changes appeals to managers who follow a “macro” approach to their investment strategies. This would not appeal to an investment manager who has a “bottom-up” approach which entails looking at each and every company that you invest in, however for “top-down” strategies” it is quick, effective, and cheap. Similarly, a strategy of “sector rotation” can be implemented by buying or selling a variety of “sector ETFs”. The proliferation of ETF funds has created a large base of index funds representing a wide variety of slices or sub-sets of each broad based index.
Caution: A number of DIY investors have been caught in the trap of holding ectors such as a Canadian Dividend fund or a Canadian Financial sector fund alongside the TSX 500 Index ETF . This causes a loss in diversification as a result of both the sector funds and the broad based index ETFs holding large positions in the same stock. Most true passive/passive investors do not require subsets of the large broad based ETF funds they hold.
One of the challenges of “active” investing is doing it in a way that prevents one strategy from counteracting a second active strategy. As an example we often see investors with equities split between a “value” fund and a “growth” fund. The net result is similar to holding the full index as whichever style does well is being off-set by the opposite style which is likely underperforming the market. It is rare for the two styles combined to both enjoy a strong year simultaneously unless the whole index also did well. A true active strategy works best when the strategy has a singular favoured approach (pick value or pick growth as an example) at any given time. Some claim they can rotate from one to another effectively and that would seem to be a valid active/active strategy; however if you own a bit of everything in your funds then you are going to reflect a passive strategy at a substantially higher cost.

Active/No Strategy: A large number of folks that sell mutual funds have an approach that utilizes active managed mutual funds alongside a non-existant strategy. That is, they buy and hold active funds with no strategy to make tactical changes to reflect market conditions. While I believe this approach likely does less damage than a poorly implemented active/active approach; this strategy is not really a strategy but rather an abdication of the advisor/planner role as an investment strategist. Investors are sold funds, often with seven year DSC penalties, and the advisor/planner never look at the portfolio again until there is more deposit money to invest (think your annual RRSP phone call). This non-strategy was very evident in 2008 when markets crashed and advisor/planners told clients to “do nothing”. Doing nothing generally reflects a lack of tactical decision making in a strategy. While the active security managers (fund managers) maintain their strategy throughout the market cycle, the advisor driven portfolio strategy is frozen in place and no course corrections are made.
Summary: Within each category there will be room for more than one approach. A proper Passive investment strategy will include tactical rebalancing, strategic rebalancing, and of course adjustments made to the index components by the index committees of the various exchanges. The passive/passive investor may also favour a market capitalization approach, average price, equal weighting or a fundamental analysis approach. Passive does not mean abandoned or ignored and does not imply zero decision making by the investor.
 As a rule you can typically classify yourself in one of the four categories above. If you are passive/passive or passive/active then ETPs are worth considering. The next installment of the blog will deal with strictly passive/passive investing strategies.