FMD Capital Management

Marrying Active and Passive Management

Written by David Fabian, October 03rd, 2017

One of the latest stories making the rounds on social media is that Warren Buffett is willing to wager (once again) that an index fund can beat active management over a 10-year time horizon.  Buffett made this bet with a prominent hedge fund manager nearly a decade ago with the proceeds going to a charity of the winners choosing.  He handily beat his first opponent and now another contender wants to take a shot at “The Oracle of Omaha”.  Read the complete post here on CNBC for all the details on this potential match-up.   

Events like this always stir up the active versus passive debate and provide an opportunity to evaluate the merits of both sides.  Personally, I fall somewhere in the middle of the whole thing and I’m happy to explain why.

Buffett is correct that index funds are the best vehicles for individual investors to own over long-time frames.  It doesn’t really matter if you own an exchange-traded fund or open-ended mutual fund.  If it’s low-cost, transparent, and tax-friendly, you are getting the most efficient vehicle to grow your capital.

On the other hand, hedge funds are loaded down with fees that significantly drag on their net returns to shareholders.  They often experience long periods of non-correlated performance due to their unconventional style.  The whole point is to create a complex strategy that you pay a lot more for with unknown results.  This type of vehicle is likely to perform better during a market downturn, but that isn’t necessarily guaranteed either.

The thing about index funds is that they are designed to be correlated with every tick of the market.  It’s going to give you every ounce of upside and every ounce of downside.  They are GOOD when we’ve been in a market that’s quiet and benign for months on end.  If that turns into a significantly extended downtrend, the psychological aspect of investing becomes a much more important factor to lean on.

Many investors think that they can just lock up money for 10 years in an account with a bunch of index funds and never touch it or change it.  But then an event like the 2000 tech crash or the 2008 financial crisis comes along and they end up jettisoning everything along the way.  There are no gate-keepers locking you out of your money.  You can sell at any time, which is what usually happens during a moment of weakness that you will later regret.

My personal take is that it IS a high-risk time to be a pure passive investor on a relative and absolute basis.  It’s also not exactly confidence-inspiring to see the lackluster hedge fund returns over this bull market or sign on the dotted line for that two and twenty management fee.

Why not find some way to marry the two together and meet in the middle?

My solution would be to commit to using some form of low-cost ETF or index funds for most of your investment accounts.  Then divide those assets among accounts or percentages that will be passive and active.

The passive portion should be left to its own devices.  Commit to just tuning it out and riding through the ups and downs no matter what.  Maybe you visit it once a year just to re-balance a few things and then grind your teeth and move on.

The active side can be a little more nuanced.  You don’t have to be some crazy level ten, options-addicted, day-trader.  You can still use low-cost ETFs and simply make subtle adjustments as you feel the need to either reign in risk or deploy capital in fresh opportunities.  This way you are still minimizing your fees and allowing yourself the flexibility to incrementally shift your asset allocation as needed.

The Bottom Line

There is no perfect solution to investing that works for everyone.  Yet, over the course of my career, I have found that meeting in the middle and striving for a sense of simplicity is probably one of the strongest foundations for a successful outcome.  Use that framework as a starting point if you are considering making a change from your current investment plan and avoid reaching for the extremes at all costs.

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