facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Do I Need a Financial Advisor? Making the Case for Financial Advice, Part 1: Active vs. Passive Investing Thumbnail

Do I Need a Financial Advisor? Making the Case for Financial Advice, Part 1: Active vs. Passive Investing

Making the Case for Financial Advice (a blog series)

Part I – Active vs. Passive Investing, and Why the Argument is Misleading


Would you rather pay more, or pay less? Would you rather lose a lot of money, or only lose a little? Would you rather have full risk exposure, or potentially limited risk exposure? In each case, the choice seems obvious. Yet, when it comes to investing, there is a pervading narrative that passive (index) investments are better than active (selective) investment management. There are two supporting arguments, one is mostly true, the other is mostly an illusion:

  1. Index investing is cheaper than active management (mostly true, from an investment fee standpoint)
  2. Active management can’t beat “the index,” so don’t pay for it (misleading on numerous levels, which we’ll discuss).

Proper portfolio diversification nullifies the index investing argument

A properly diversified portfolio renders point #2 (above) invalid. Active management is commonly portrayed as exhibiting inconsistent, expensive performance that is inevitably the wrong way to invest, and index investing is portrayed as cheap, unbeatable, and therefore good for you. Keep in mind, though, that a properly diversified portfolio isn’t invested 100% in the S&P 500 companies, even if it consists solely of equity (stock) investment. Most, if not all, financial advisors - and every 'robo advisor' - offering advice on how to build a portfolio asks a series of questions to determine your investment goals, timeline, and comfort with market risk. We (advisors) ask these questions because we’re legally bound to offer investment advice that pairs with a client’s risk profile. That’s not even adhering to a fiduciary standard, that’s simply meeting a suitability standard, and that standard results in a broadly diversified equity portfolio, typically consisting of large, medium, and small companies headquartered within, and outside of, the United States.

Be wary of what you read (yes, even this blog). Passive (index) and active investing are not investment styles in opposition to one another. Many advisors incorporate both strategies within a portfolio, effectively creating broad market exposure enhanced (potentially) by selective investment. A thoughtful investor will not base their investment decisions on headlines in the news.

Remember, journalists aren’t financial advisors. They are not exposed to fiduciary liability. While many may provide fantastic insights and wonderful observations, they don’t have a legal obligation to you. They do, however, have a job to do. And, like portfolio managers and financial advisors, their worth will oftentimes – right or wrong, for better or worse – be determined by performance, i.e. number of readers in a given time period, measured by number of clicks on a headline link. If their headlines don’t attract readers, then their “performance” may lag their peers in today’s 24/7, news-at-your-fingertips world. So, in theory, they’re going to make a snappy, attention-grabbing statement that will pique your interest (I say in theory because I’m not a journalist, nor have I worked for a news outlet, but the performance-based, revenue-generating business model is fairly common).

Be sure to analyze and verify that statement before trusting it as fact. Misleading headlines can skew data toward a specific one-or-the-other, us-or-them narrative in an effort to make readers draw an intended conclusion. Here are a couple of examples (the second headline is popular, but false on a variety of levels):

Factors that should influence an investment decision

As a financial advisor, I consume, digest and (attempt to) retain information from a myriad of industry resources – blogs, articles, white papers, webinars, seminars/conventions, credential-bestowing coursework – from a variety of channels. This information forms and guides my processes, actions, and interactions. I don’t believe decision-making should be instinctual when the decision – and ensuing recommendation – is investment and/or financial advice. An investment recommendation, or recommended course of action (in the case of financial planning) should not be based upon irrational fear or attention-grabbing headlines. In other words, it shouldn’t be impulsive. It should be objective, rational, and grounded in factual data.

Primary factors that should influence an investment decision create the framework for an investment portfolio. As an advisor, I assess a client’s short- and long-term goals, liquidity needs, investment risk tolerance, appropriate portfolio design (asset allocation) as a result of risk tolerance, timeline until retirement, retirement income need, and a client’s investment sophistication.

Secondary factors can influence the tailored feel of an individual portfolio. Considerations at this level include a client’s preferred investing style, i.e. loathes/loves mutual funds, seeks a socially responsible mandate, desires a tech-heavy portfolio, etc.   Another factor is my experience, knowledge, and trust of an investment firm, which influences the management companies used in the portfolio. I also review the analysis of investment managers – and specific investments – produced by an objective third-party analyst.

Tertiary factors influencing an investment decision? Performance and expense. But not just “performance.” Risk-adjusted performance relative to peers, and/or a suitable benchmark index, with at least three, but preferably five or more, years of reporting history. Used correctly (held long term, through market ups and downs), index investing yields performance comparable to an intended index. It also carries a comparable amount of risk exposure, experienced by the investor as volatility.

You may be wondering why fees (expense) and performance are not a primary or secondary consideration, despite the emphasis placed on it by various news, market, and investing outlets. It’s a legitimate question. I do, after all, consider myself fee sensitive (I have a firm understanding of the fees I pay in my own retirement portfolio), and transparent, openly addressing investment fees, and my advisor fee, with current and prospective clients. And, of course, we all want to see strong performance in our portfolios. Here is my rationale for not elevating investment fees (I use the same rationale for evaluating a financial advisor’s fee): effective portfolio management justifies the expense of an active management strategy. Likewise, passive, index-matching investments have illustrated that low fees equate neither to superior nor inferior performance. And the rationale for not placing emphasis on historic performance is two-fold: we want to avoid chasing returns, and the disclosure in every investment commercial and piece of investment marketing literature is the same, "Past performance does not guarantee future results." The easy-to-read articles of active versus passive investing often highlight the dual benefits of index investing, index-like performance and low cost, while consistently repeating the “you can’t beat the index, so don’t try” mantra.

The argument is disingenuous at its core, because it does not address four critical questions:

1. Which index?

Dozens, if not hundreds of indices exist today, and some investment firms even create their own analog versions, allowing for nuanced, criteria-specific tracking of investment securities (stocks, bonds, etc.) within a broader index. While the S&P 500 is considered the current standard index which others are measured against, it should only be used as the measure for equity (stock-based) investments that are comprised of the 500(ish) largest US-based companies (based upon capital). If your portfolio consists of equity (stock) investment beyond these 500 or so companies, then the S&P 500 it is not an appropriate comparison measure by itself. A more accurate comparison tool is likely a blended benchmark (combination of indices) that matches the construction of your portfolio.

2. What’s the time period?

When we’re attempting to “beat the index,” what’s the temporal measure – 1, 3, 5, or 10 years (or perhaps longer)? Always look for the supporting data before accepting the base claim, and keep in mind that past performance does not guarantee future results. Case in point: using Vanguard’s Long-Term Treasury ETF as a reference, we have evidence that long term treasury bonds have better 3-year and 5-year annualized performance than the S&P 500 TR (total return), as of March 31, 2020. Looking forward, though, it’s likely that equities will outperform. Just some food for thought.

3. Is the performance reported as annual, annualized, or cumulative – and is this net performance?

I would suggest that for the long-term, retirement focused investor, cumulative performance, net of fees, should be the primary measure, potentially for a length greater than 10 years (depending on goals and retirement horizon). This is aligned with the strategy of managing for total return. While it is true that a majority of large cap investments don’t beat the S&P 500 over various periods of time, there are quite a few investments with consistent records of outperformance. Portfolio managers and investment styles may periodically fall out of favor, but there are many active management firms managing funds with long- and short-term track records that consistently outperform a comparable benchmark. An attentive, prudent advisor may be able to help you stay up-to-date regarding these manager and market trends.

4. What is your investment goal?

Does “beating the index” truly matter to you, or is it more important that your retirement portfolio be aligned with your long-term goals, invested in accordance with your specific risk tolerance? A balanced portfolio may not yield eye-popping annual returns year after year, but it could offer some buoyancy when the market takes a sudden dive.

Think critically and try to avoid bias

We should think critically about these four questions, and be mindful of potential biases – which may crop up in a Google search, but may also stem from within. While passive investments offer broad investment exposure at a low cost, active management strategies may offer enhancements, like a more selective investment process (potentially yielding better long-term results), or decreased volatility compared to the broader market (potentially reducing losses during a market decline), which index investments don’t provide. It may make more sense to blend the two strategies, rather than treating the strategies like opponents that mandate an investor choose a side. But, again, this depends on many other client-specific needs and goals, which should be considered in detail prior to the investment portfolio discussion. Feel free to reach out to me if you’d like to discuss this topic in greater detail.

Email us your thoughts, questions, or concerns below: