Active and Passive Investment Management

Posted on: March 5th, 2013

Active Investment Management utilizes the insights and skills of a money manager in an effort to provide a return that exceeds a market benchmark, such as the S&P 500.

Passive Investment Management simply seeks to replicate the returns provided by a market benchmark.

One of the unique characteristics of the Wealth Management process at Seaside National Bank & Trust is that we use both active and passive investment management in the pursuit of our clients’ objectives. The debate as to which approach is better has been so polarizing that very few, if any, wealth management operations ever use both active and passive management. And yet, many of the largest and best advised pensions and endowments do incorporate elements of both.

The academic literature has long argued for exclusive use of passive management techniques, primarily through the use of index funds. This argument is based on the idea that markets are efficient, and therefore incorporate into their pricing all that is known about the risks and rewards inherent in individual securities. It follows from this that any return achieved over and above the market benchmark is a statistical aberration that will probably be undone by subsequent under-performance. In fact, most active managers, for all their fees and efforts, do not exceed their market benchmark. The academic literature also correctly points out that index funds cost much less than actively managed funds, are relatively tax-efficient, and are fully diversified. Fees and taxes are a significant drag on an investor’s net return.

The advocate of active management scorns indexing by pointing out that the benchmark is merely an unmanaged, “average” measure of market performance – one that intelligent observation, analysis and strategy ought to be able to beat. Although there is much evidence to support the efficient market hypothesis, we also have to acknowledge the existence of extraordinary investors, like Warren Buffet, Ken Heebner and Chuck Royce who have consistently exceeded market returns over extended periods of time. These investors are not statistical aberrations; they can articulate clear principals and strategies that have allowed them to deliver superior returns.

We use both active and passive investment in our client’s portfolios because we recognize that both methods have different strengths and can complement each other. We will typically “anchor” a portfolio with an allocation to an index fund in order to ensure full diversification in a given asset class, lower the cost of the portfolio, and secure a measure of tax efficiency. Index funds also tend to perform especially well on a relative basis when markets are moving upward. We will then complement that investment with an active manager who has a concentrated portfolio, a solid record of beating the market benchmark and has a proven ability to protect value in a down market. We believe that this combination gives our clients the advantages of both strategies.

Why don’t more providers use the power of both active and passive management? Sadly, the answer lies in pride and economics. The fees charged by index funds are too modest to pay commissions, loads or marketing incentives to advisors who might otherwise recommend them. In exchange for higher fees,
most investment shops insist on burning calories in an effort to beat a benchmark that they rarely match, let alone exceed.

Active and passive investing – we use the strengths of both to help you achieve your investment goals.

Investments are:
Not FDIC insured
Not guaranteed by Seaside National Bank & Trust
Subject to risk and may lose value