September 23, 2014

Active vs. Passive Asset Allocation

Active vs. Passive Asset Allocation Strategy

Despite the raging debate, there seems to be strong empirical evidence that most investors would do best by adopting a passive asset allocation strategy and buying low-cost index funds through companies such as Vanguard, perhaps under the supervision of a well-qualified financial adviser or CPA. Image © iStockphoto/Thinkstock

A large debate has emerged in the money management field on the topic active asset allocation versus passive asset allocation. There are merits to both approaches, but the ultimate determination of what is right for your personal or business asset allocation portfolio is a decision only you can make based on your skills, knowledge, interest, and the time you can commit to managing your money.

The Difference Between Active and Passive Asset Allocation

Active asset allocation means that you are engaged in actually selecting individual investments once you’ve chosen your asset allocation model. For instance, if you and your adviser decided to put 35% of your capital to work in blue chip stocks, you would actually read hundreds of annual reports and select the companies that you believed offered the best return for your money. Alternatively, you could buy an actively managed mutual fund or exchange traded fund, for which you will pay a substantially higher management fee, perhaps between 1% and 2% of assets each year.

Passive asset allocation is a completely different approach. If you decided to put 35% of your money into blue chip stocks, you may just buy the Diamond ETFs (Symbol IYY), which has an expense ratio that is 1/10th or 1/20th of most actively managed funds, and you would instantly own a portfolio meant to replicate the experience of the Dow Jones Industrial Average.

An active asset allocation investor may say, “I want 50% of my money in stocks and 50% in bonds. Of my stock component, I want 1% invested in the following companies: General Electric, U.S. Bancorp, Wells Fargo & Company, Berkshire Hathaway, AutoZone, Target, Wal-Mart Stores, Procter & Gamble, Johnson & Johnson …” The passive asset allocation investor would simply say, “I want 50% of my money in stocks and 50% in bonds. Buy the Dow Jones ETF with the stock component and an intermediate bond ETF for the bond component. That way, I own hundreds of investments for the price of two low-cost brokerage commissions and don’t have to worry about picking individual investments. I’ve got better things to do with my time.”

The Active Asset Allocation Performance Fee Hurdle

The biggest hurdle to active asset allocation investing performance is that active portfolio managers often charge 1% to 2% of assets in the form of a “management fee” that is deducted from the mutual fund each year. If the passive ETF earns 9% and the active ETF earns 10%, you may end up with the same 9% in your pocket, plus you’re likely to pay higher taxes with the actively managed fund because there is greater activity than a buy-and-hold index. Obviously, if you hold your ETFs in a tax-advantaged retirement account, that’s not a problem. For those investing through regular brokerage accounts, it can be a concern.

Which Asset Allocation Strategy Is Right For Your Portfolio

As we said earlier, only you and your adviser can determine the asset allocation strategy that is right for your own situation, financial resources, and interests. Just realize that some of your decision should be based upon your personality. If you love selecting stocks, you may want to have some portion of your portfolio dedicated to active management.

You also shouldn’t make the mistake of thinking passive vs. active asset allocation is an all-or-nothing proposition. You could have 80% or 90% in lower-cost, passive investments and retain that 10% or 20% for your active managed investments. That way, you have the best of both worlds.