We are convinced
that passive portfolio management is a superior
approach for investing our clients' wealth and helping
them achieve their goals. As a result, we primarily
use passive, asset-class institutional funds when
designing client equity portfolios.
The term "passive"
refers to the method by which securities are selected
to be included in an investment portfolio. A passively
managed portfolio simply includes all market securities
that meet certain objective, unchanging criteria.
For example, a passive portfolio might include all
stocks in the S&P 500 index or it might include
only large European growth company stocks. In either
case, the portfolio would simply buy and then permanently
hold all qualifying stocks.
In passive management, there is no attempt to research
companies, to attempt to choose "good"
stocks and exclude bad ones. No manager exercises
subjective judgment in selecting securities. Passive
portfolios are not designed to "beat the market"
but rather to closely mimic the returns of various
asset classes.
The alternative to passive management is, of course,
active management. An active manager uses research,
analysis, economic predictions, and subjective judgment
to select securities that are considered undervalued
expected to outperform the general market in the
future.
Academic research
has consistently shown that active management is
usually a fruitless waste of effort and (especially)
money. Although some active managers do "beat
the market" over short time periods, it is
extremely difficult to identify them in advance.
Most active managers underperform their benchmarks
each year.
Most Wall Street media attention is focused on active
investment activities that have little impact on
the returns investors receive. Tune in the financial
television programs or read the popular personal
finance magazines and one discovers that most investing
stories are devoted to selecting stocks and timing
market movements.
Research has shown, however,
that stock picking and market timing determine less
than 10% of investor returns. Amazingly, over 90%
of portfolio returns are the result of how the investments
are allocated among available "asset classes":
_Stocks vs. bonds vs. cash,
_Large companies vs. small companies,
_US companies vs. international companies,
_Value companies vs. growth companies.
The reason that
stock selection and market timing have so little
impact on returns is that capital markets are extremely
efficient. Stock prices instantly adjust to incorporate
all known information about the company and the
economy. Thousands of brilliant Wall Street professionals
with access to the world's best research continuously
compete with one another to discover "undervalued"
stocks. As a result, there are no stock "bargains"
for active managers to buy. All securities are priced
more or less fairly by the market on a daily basis,
incorporating all available knowledge.
Rather
than spend our energy on issues which contribute
little to client returns, we focus exclusively on
the "90% Question": What asset allocation
is optimal for the client's individual circumstances.
Passive portfolios cost much less to manage than
their actively managed alternative. The expenses
of passive mutual funds are normally 50-80% less
than an active fund in the same asset class. This
often gives the passive investor an immediate advantage
of 1% or more in net returns.
Passive portfolios
are more tax efficient. Taxable
capital gains are generated any time appreciated
securities are sold within a portfolio. Passive
portfolios, with their "buy and hold forever"
approach, seldom sell securities, resulting in very
low income tax costs.
Passive portfolios have
predictable styles. A passive investor knows
exactly what types of securities he or she is invested
in. Active managers, on the other hand, can vary
the composition of their portfolios significantly
over time - a problem known as "style drift".
