Creation of an Investment Portfolio
Tom Diem, CFP®, ChFC®
Active vs. Passive vs. Structured
When you constructed your investment portfolio you invariably followed one of three schools of thought. Active Management, Passive Management and a Passive variant called Structured Portfolio served as the main contenders for your money. They still do, so let's take a look.
Active Management
Active is the most popular method. For many years, almost every retail investment firm serving the public has touted their Active Management prowess. Active relies on forecasts of individual investment prices. These forecasts assume the market has mispriced many investments and the Active Manager can routinely identify these mispricings. The mispricings suggest the market price today is either too low or too high. The Active Manager often bases these forecasts on the price of the investment relative to their estimate of future profits and sales of the company being researched. These forecasts are based on the recent profits-sales reports the researched company has published. The reports are compared to reports of like companies in the marketplace. If the company has a strong track record of growing their sales and profits relative to their competition, the company is assigned a premium. This premium is then compared to their current stock price through a few financial ratios and then it is determined to be either a stock to Buy or Sell. There’s a little more. There must be a compelling story as to why the company is expected to continue its record of growth into the future. Armed with these tactics, the Active Investment Manager sets out to achieve superior performance by actively buying and selling investments within the portfolio.
Passive Management
This approach is far simpler. Think-‘It’s Hard to Beat the Market’. Now, hold that thought for a moment.
Passive Management is assembling a portfolio of index funds to replicate stock and bond markets. Index funds are mutual funds that replicate a stock or bond index. An index is a group of stocks, bonds or stock-bond mix following a set of rules to be included in that particular Index. Two well-known indexes are ‘The Dow Jones Industrial Average’ and the ‘Standard &Poors 500’. The thirty companies in The ‘Dow’ are industry leaders. Dow Company selects the industries and companies. Dow’s intention is to create an index best reflecting the composition of the current American Industry leaders as a whole. The ‘S&P 500’s composition includes five hundred of the largest companies in America. The composition of indexes changes over time. Years ago, both indexes included many traditional manufacturing companies. Todays Dow and S&P have more technology, finance, healthcare, retail and diversified companies. There are many indexes around the world. Some include foreign companies- some have small companies-some have companies of a specific country or region of the world. The Passive Manager accepts market returns through the use of low cost index funds. Passive Managers eschew the idea of achieving superior performance relative to market returns through the use of active management.
Why passive over Active?
The body of historical evidence about passive outperforming active is immense. Twice a year, Standard & Poors publishes a report called ‘Standard and Poors Index versus Active’. The numbers within the report reflect the failure rate of Active Managers to outperform the closest fit index. The results are daunting. Anyone wanting this report may either email me at tom@diemwealth.com or call me at 260.918.8800 and ask for SPIVA report.
Structured Portfolio
While Passive in nature, Structured is different from both traditional Passive and Active styles. Structured does not rely on short-term forecasts nor does it subscribe to a limited set of rules. Through the use of institutional funds, it screens out undesirable investments with a strict process. The screens are applied daily. The portfolio is also designed to provide the investor a predictable level of risk. Different types of investment prices move differently over time. When this happens, the portfolio is re-balanced back to the asset mix and risk level desirable to the investor.
Why Structured is the Better Option?
Utilizing over 60 years of Nobel Prize winning research, Structured does some very beneficial things not done in active and passive styles. The screens for desirable investments and the proper asset mix are based on historical evidence of what really works for all kinds of investors. This process leads the investor towards the highest expected return-bang for their accepted level of risk-buck. The auto-rebalancing of the portfolio maintains the asset mix and risk level chosen by the investor.
Would you like to know if your portfolio is getting the most return-bang for your risk-buck? Please give me a call to discuss how Portfolio X-Ray™ and Portfolio MRI™ can be beneficial for you.