Case for Personal Active Portfolio Management
A common debate among investors and financial professionals is the value of active versus passive portfolio management. Active management in this context means that portfolio managers either at mutual fund companies or investment advisory firms select investments for purchase by a portfolio based upon various criteria such as valuation, earnings, new products or management. Passive management means that managers buy a relatively fixed group of investments and maintain stable proportions of these static holdings within the portfolio or fund. Both these styles require rebalancing transactions and this trading is a significant cost that is incurred by the portfolio. The debate centers on the value of the management expertise. Below are four considerations that enable investors to put this decision into perspective:
The case of active management is that market activity is based on the economic principle of creative destruction. Industrial sectors and individual companies have core products, processes and technical advantages that cause some to grow and expand, while competitor sectors and companies might decline and contract. Some investments will grow even as others decline in gradual or dramatic fashion. Thus every day there is new growth and new contraction occurring that becomes evident in financial data and ultimately in market prices. This is the history of economic and indeed human progress. Active investing is an attempt to discern the sectors and companies that have prospects of growing faster than the average. Active management is an approach that tries to identify undervalued securities and by investing in such, achieve a net outperformance relative to a benchmark. While there are no guarantees in investing, over time a skilled active manager should be able to out-perform the benchmark. This selective process is only effective if the costs of research and selective investment turnover is less than the enhanced return offered to clients or shareholders. Passive investment is akin to limiting one’s gains or losses to an average but not attempting to out-perform the average.
Financial markets are considered highly efficient but also not perfect. Even as human decision-making is a combination of rational considerations and emotional reaction, so financial markets have elements of rationality but also of emotions, such as fear and greed. Furthermore, there is great dispersion of different investors, some who are pursuing more short term gains, while other investors are seeking long term returns. Perhaps the greatest potential service that active management provides is the ability to avoid emotional decisions and let dispassionate professionals make transactions on a rational basis.
Frequently, investors have their own value criteria which they want an investment manager to honor. These criteria might be financial performance or sectoral preferences, or social responsibility criteria. While some larger funds may target these criteria, personal portfolio managers have the most flexibility in meeting the complexities of these client wishes.
Open ended mutual funds and Exchange Traded Funds (ETF’s) manage many millions, often billions of investment funds. These funds must satisfy the buying and selling that investors demand after each day of trading. Thus they often buy after a large market surge, and sell after a large market decline, locking in a bias of buying high and selling low. This is known as volatility risk cost. The sheer size of these funds means that they have a material impact on market prices. Furthermore, funds change their portfolio strategies, sometime frequently, which reapportions investments in the fund. This incurs a further trading cost known as turnover cost. Passive funds such as index funds have less turnover cost, changing only when the index changes. Market data accumulated by CNNMoney (“86% of investment managers stunk in 2014” March 10, 2015) indicate that over 80% of all funds fail to outperform their benchmarks in any given year. This is due to large degree to these size related costs, but in fact, all funds have costs that reduce investment returns.
Registered Investment Advisory firms known as third party money managers post their annual portfolio performance and also have a common portfolio for all clients. Thus they act to some extent like mutual funds who with large holdings that must be acquired or divested in a short period. All clients get the same investment performance and to the extent that these firms react to market swings, incur volatility risk as well. Frequently, the more money under management, the greater the volatility risk is, as the fund begins to reflect market forces. Furthermore, the more a fund trades to react to market forces, the higher the transaction costs become, eroding the inherent return on investment even as they attempt to profit from emerging trends.
Individual portfolio managers have the flexibility to manage each portfolio as distinct and uniquely tailored to the client’s risk tolerance, goals and personal profile. These managers forego the benefit of economies of scale but are not bound to trade consistently and incur the losses associate with volatility. Furthermore, they can substantially reduce turnover costs as well by adopting stable screens that identify, on a quarterly or annual basis, investments that represent an inherent value relative to the market. Thus individual portfolio managers can approach an optimum level of turnover that is far lower than the turnover costs which larger funds must absorb.
Mutual Fund Costs and Fees
Many other costs and fees are subtly woven into fund expenses which are outlined below:
12b-1 fees are distribution fees which are commissions to brokers selling a fund.
Sales commission front or back end loads.
Fund of fund loads which occur when a mutual fund holds shares of another fund.
These fees can be as low as a few tenths of a percent or as high several percent, depending on how long an investor holds the fund, whether the fund is actively or passively managed, and what the fund directors determine to maximize.
Evaluating Investment Managers
Finding an investment professional to actively manage one’s investments is neither easy nor riskless. For third party money managers, there is a track record but there is also the volatility and turnover risk as well as an impersonal relationship. Referrals from satisfied clients are also possible, but of course this is anecdotal evidence. There is the survivability criteria which assumes that managing investments is an acquired skill and those that have been in the asset management industry for a longer period have learned a lot of lessons. Credentials such as a CPA or CFA are signs of a longer term commitment to the financial industry, but of course, these also have a cost that must at some point be recovered. Additionally, one can judge investment professionals based upon their fee structures. Too high or too low a fee is sign that the advisory fee structure is skewed or unreasonable. There is also the background information that the SEC and other institutions hold on all investment professionals which can be obtained either on line or by request. Finally, potential clients should interview the investment manager if possible to assess their common values, trustworthiness and competency. The more degrees of separation between the client and the manager, the more likely that important client criteria may not be considered in investment decisions. Most clients approach this decision based on some or all of these criteria.
Personal, active financial portfolio managers, such as KENETEX Wealth Management, have the ability to manage portfolios on a personalized, custom basis to minimize trading cost, optimize investment selection and social responsibility, reduce inherent institutional costs and provide a valuable service to investors intent on managing their wealth.