Our clients often ask their wealth advisor to explain the differences between indexing, asset-class investing and passive management.
It’s easy to see why these terms need clarification; after all, they’re describing closely related concepts that share many similarities.
But the terminology frequently used when discussing this investment approach -- such as index funds, asset-class funds, and passively managed funds – also have many notable distinctions. Here’s the low-down on these commonly used terms to help you make a well-informed decision as to which of these wealth management strategies to incorporate into your portfolio.
Index Funds: How Do They Fit Into Wealth Planning?
Index funds are mutual funds designed to match or “track” a market index, such as the Dow-Jones Industrial Average (DJIA) or S&P 500. Historically, indexing has performed better than the vast majority of actively managed mutual funds; from 1998 to 2013, only 25.6% of actively managed funds outperformed their benchmarks. Makes you wonder why so much investment guidance leans toward active management.
The DJIA -- a.k.a.. the “senior index,” so-named for its seniority -- has been around since the 1800s. While it may be the oldest index, it only contains 30 stocks. Given that there are more than 3,600 stocks out there, 30 (arbitrarily chosen) stocks doesn’t seem very representative or adequately diversified. Several index funds replicate the DJIA, but again, they’re not diversified – and therefore not a good choice.
In contrast, the S&P 500 is more representative – 16 times more – than the DJIA. Index funds that replicate the S&P 500 attempt to track the index as closely as possible, with a focus on minimizing “tracking error,” or the difference between the benchmark an investor tries to achieve the return they actually receive.
Should Asset Class Funds be in My Comprehensive Financial Plan?
It depends. Not all asset-funds are created equal. We feel that asset-class funds that are passively managed can have many benefits such as:
Relatively low cost
However, asset-class fund aren’t based on a specific, existing index. Rather, asset-class funds are created through the quantitative – as opposed to subjective -- identification of factors that reflect a persistent connection with either risk or return.
Asset-class strategies allow for more flexibility than do index funds, with their strict emphasis on eliminating tracking errors, because it's not necessary to include every possible equity. If portfolio managers can't find sufficient quantities of a criteria-meeting stock at a particular time, they can just wait for better availability, rather than being forced into a distress purchase.mallest 5% of market cap, but exclude all IPO stocks – a class with historically poor returns.
Should More Investment Professionals Recommend Passive Investing?
Both indexing and asset-class investing – as well as most exchange traded funds (ETFs) -- are wealth management strategies that fall under a generic, inclusive term: Passive management. In essence, passive management simply means not trying to beat the market and generate excess returns through stock picking or market timing. Rather, the goal is to duplicate returns of a chosen market segment.
Given passive management’s history of outperforming active management, it’s perhaps ironic that this strategy’s main drawback is the connotation of the word “passive.” Most contexts – sports, business, even language (“I prefer active voice” instead of “Active voice is preferred by me.”) show a bias toward active participation over passivity. But when it comes to investing, the real choice is between passive management and active mismanagement.