April 20, 2020
Depending on the economic environment, there are ways to leverage both active and passive investing.(GETTY IMAGES)
THE MARCH MARKET sell-off threw us into a bear market after the longest bull market in history. With the economic downturn, investors might be wondering if they have the best investment strategy implemented for their portfolio.
Prep Your Portfolio in a Recession
In the investing world, the argument of whether active or passive management is more efficient has been a long debate. The reality is, depending on the economic environment, there are ways to leverage either approach since each strategy strives toward different goals.
The downturn may influence asset managers to adopt one management system over the other, but there are certain scenarios to explore that allow individual investors to add value by using a mix of both in a bear market.
Let’s delve into these two investing approaches to see which one is right for you by looking at the following:
- The difference between active versus passive investing.
- Strategies that work better in a recession.
- Adopting both active and passive strategies.
The Difference Between Active vs. Passive Investing
There is a fundamentally different focus for active and passive investing: Active managers do ample research and take an analytical approach in their investment strategy, while passive index funds rely on diversification with a long-term investing approach.
Actively managed funds have portfolio managers that attempt to beat the average stock market performance by taking advantage of short-term market fluctuations. As the name suggests, active investors constantly monitor the prices of their positions to find buying and selling opportunities.
Active investors charge fees higher than one percent as compensation for the work that goes into managing this type of fund.
Anderson Lafontant, an investment advisor at Miracle Mile Advisors in Los Angeles, maintains that active investors who are following higher risk are seeking higher returns in the short term, “They look to take advantage of mispricings and undervaluations and are willing to pay higher fees and more taxes for these returns.”
Passive investing, on the other hand, has significantly lower fees since there is no management required. Its focus is on “buying and holding” indexes for the long term.
“Passive funds are less expensive, more tax-efficient and generally set to do well over full market cycles. While they can track the market down during a recession, they are poised well to rebound in the future,” Lafontant adds.
Since an investor’s positions are diversely spread across different industries, passive investing does not involve research, monitoring or analyzing the fund. The goal of a passive investment is to meet stock market performance rather than beat the index’s benchmark, like active funds.
Which Strategy Works Better in a Recession?
The nature of passive funds is more certain and secure. A passive investor generally knows what their expected earnings will be. Active fund performance, however, can be more difficult to predict since there is no guarantee of beating the market.
Similarly to the ebbs and flows of market activity, active and passive strategies are cyclical.
In previous decades, active managers performed well in market downturns; recently, however, results have been very mixed, says David Lafferty, chair of the Active Managers Council and a chief market strategist at Natixis Investment Managers, both located in Boston.
“In the current cycle for equities, passive is doing reasonably well because the mega-cap names continue to outperform, which makes it difficult for active managers to overweight the largest names. When the biggest of the big outperform, passive is hard to beat because the mega-caps are holding up well,” explains Lafferty.
It can be assumed that with more analytical research, monitoring and higher fees, actively traded funds would have higher returns than index funds. Based on historical performance, experts say that in a low-volume market environment, passive strategies are hard to beat.
Generally, experts argue taking the active approach can serve better during a bear market.
Index funds have an advantage with their low-cost structure and broad exposure that limits single stock/concentration risk, says Matthew Timpane, a senior market analyst at Schaeffer’s Investment Research in Cincinnati.
“But once volatility kicks in, that is where active strategies can shine.”
When the stock market is down, an active investing approach can result in higher gains since there is more flexibility in this strategy compared to passive investing.
During a recession when the market is volatile, active money managers can exploit market dislocations while applying risk-management tactics more efficiently. Active managers can mitigate risk during a recession by allocating less to sectors that are vulnerable in a recession.
“Active typically is a better approach during bear markets since you can control risk and provide downside protection. The flexibility of asset allocation and equity selection is an advantage during volatility if managed appropriately. If you are not managing your portfolio’s active strategy, selecting the right fund manager is key here,” Timpane says.
Adopt Strategies From Both Approaches
To become a better investor, you don’t necessarily have to be a full-on active investor or wholeheartedly take a passive approach. Rather, it can be wise to merge strategies from both approaches together: Pick and choose elements of either school of thought that fits your risk tolerance.
Taking the best of both worlds can decrease risk and maybe even result in some returns in a down market.
Investors buying an index are expecting that the fund mimics the performance of a major index, like the S&P 500. A passive strategy can work for anyone, whether you are new to the world of investing or a seasoned market veteran.
“Clients that are more risk-averse may want the option of being conservatively positioned,” Lafferty recommends. “If there isn’t a big opportunity to generate additional returns and you just want to own a high-quality, basic portfolio, then passive is more appropriate.”
An investor who can take on more risk and potentially experience loss – but wants to generate excess returns – can be a fair candidate for active investing.
A traditionally passive investor who may want to take a more hands-on approach can start by being more informed on active investing strategies to incorporate in their portfolio, says Todd Salamone, senior vice president of research at Schaeffer’s Investment Research.
Research says you can start to “emphasize or de-emphasize certain asset classes in [a] portfolio during certain environments, such as exposure to equities, bonds, currencies, commodities and/or volatility. After all, an asset class of some kind is usually in a bull market, and identifying that asset is critical in maintaining an active investing strategy,” Salamone says.
Someone who has the time and commitment to learn and understand other asset classes like real estate, gold or digital coins “can add those to her investment portfolio and also research which actively managed international and domestic stock funds are good to buy,” says Tim Shaler, a chief economist at iTrustCapital in Newport Beach, California.
Shaler stresses that it’s important to understand that “there will be a time to move some money out of the actively managed funds and into lower-cost passive funds when the sharp volatility has decreased back to normal.”
An investor who wants to make better decisions about investment management should understand the risks, offsets and implications of both active and passive investing. Considering the strengths and shortcomings of both approaches can make you well-positioned during a recessionary market environment.