For many investors, using both active and passive strategies is appropriate. Senior Director of Investments and Fiduciary Services Adrian Miller and Regional Chief Investment Officer Cameron Hinds discuss strategies to consider in this current economic environment.

Audio: Perspectives on Passive and Active Investing (Audio)

Transcript: Perspectives on Passive and Active Investing (Audio)

Interviewer: Adrian Miller, Senior Director of Investments and Fiduciary Services, Wells Fargo Private Bank
Interviewee: Cameron Hinds, Regional Chief Investment Officer, Wells Fargo Private Bank

Adrian: Hello, I’m Adrian Miller, Senior Director of Investments and Fiduciary Services for Wells Fargo Private Bank. Joining me is Cameron Hinds, Regional Chief Investment Officer for the Great Lakes region.

Cam, the debate over whether passive investment strategies are better than active investment strategies continues to rage, partly due to the perceived underperformance of active strategies in recent years. In this podcast you are going to share a slightly more nuanced view, that the answer isn’t as simple as it may at first seem. For the sake of our audience, what is the difference between the two?

Cam: Well Adrian, I would summarize the two as follows:

  • Active investing aims to profit from the skills of an investment manager who strives to earn a greater return than a particular market index. It involves substantial research and potentially a fair amount of trading. These activities raise the cost of investing, meaning the manager has to beat the market by a margin sufficient to cover the higher costs associated with this type of approach.
  • Passive, or index-based, investing seeks to earn the average return of an index or market segment. A passively managed fund’s goal might be, for example, to track the S&P 500 Index’s performance. Classic indexing means constructing a portfolio with the same market capitalization mix as exists in the marketplace.

Adrian: So Cam, the common perception is that active investors have struggled to outperform the markets over the course of the eight-year bull market.

Cam: You’re right, Adrian, however, we don't believe investors should dismiss active strategies. In general, other than fees, the primary reason for their underperformance has been cash holdings and their exposure to holdings outside of a particular index, such as international positions. Looking forward, cash holdings may become less of a drag on performance if interest rates move higher and given the more positive outlook for many international markets, we anticipate international exposure may help performance going forward.

Adrian: So in essence what you are saying, Cam, is that you don’t expect the next five to seven years to be the same as the last five to seven years.

Cam: Exactly, Adrian. It would not be surprising to see the emergence of an economic recession, market corrections, and increased volatility over the next few years. This clearly would not be the same investment environment we’ve experienced since 2009. If such changes in the economic landscape occur, they may favor active investors.

Adrian: And I think that it’s fair to say that not all passive strategies deliver to investor expectations.

Cam: That’s right Adrian. It’s important for our listeners to understand that even passive strategies have to be carefully selected if they are going to fulfill the role that you want them to play in a portfolio.

For example, low-volatility ETFs have been one of the more popular “smart beta” strategies used by investors over the past few years. The idea is to take less risk (volatility) in an individual stock portfolio yet actually outperform the indexes (in this case the S&P 500 Index). In a comparison of low-volatility ETFs of money weighted performance vs buy and hold by Empirical Research Partners Analysis, suggests that the “buy and hold” performance has been quite good for this ETF strategy; however, the dollar-weighted performance (which accounts for the timing of when funds actually flow into an ETF) indicates the average investor’s performance per year has been around 1.75 percent less than the ETF itself. This is very strong evidence of investors buying the strategy after it has gone up and selling during points of weakness. To avoid these emotional investment mistakes, it may be beneficial to work with an investment professional to help with positioning of passive strategies.

Adrian: So, Cam, what are investors to make of this information? Do you believe they should they be focusing on active strategies going forward?

Cam: Not at all, Adrian. My point is that when you compare the two strategies, the potential outcomes are seldom as simple as they may appear to be, particularly when investors decide to use passive strategies. In addition, investors shouldn’t rely on market conditions staying the same over time. So what we do advocate is that investors consider a mixture of both active and passive strategies for their portfolio. We also recommend that they work with their investment professional to help understand the characteristics of each strategy and to determine the right mix for their individual circumstances.

Adrian: Cam, I want to thank you for joining me today to discuss the importance of passive and active investment strategies. And a special thank you to our audience for joining us.