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Actively Using Passive Investments

How advisors are using index funds to create dynamic portfolios without owning stocks.

Helen Modly, 03/01/2007

Many advisors write off the idea of using mutual funds and exchange-traded funds because they fear their value will be questioned by clients, who might wonder why they couldn't have bought the funds for themselves. There's a perception in some advisors' minds that only by trading individual stocks can they justify their fees. What these advisors forget, however, is that those fees may not be justified by the performance of the stocks they pick, and that their performance was earned by accepting more risk than their benchmark index. When the professional money managers running billion-dollar mutual funds have difficulty beating an index, why should clients believe that you will? Instead, trade on your skill to design the very best portfolio for each of your clients.

It is a common mistake to assume that any advisor who uses index funds is passively accepting mediocre market returns. There are many scenarios where index funds can be employed in a truly active management style. Today, many new indexes are being developed, some of which track very narrow market segments. With the development of passively managed funds to track these new indexes, it is becoming easier to create very dynamic portfolios without owning individual securities.

The Traditional Passive Model
The traditional model is as simple as owning an S&P 500 index fund and nothing else, having dividends and capital gains reinvested every year and just adding dollars to the account over time. Don't laugh. This is exactly what many employer retirement plans did for decades. As unsophisticated as it sounds, if we had all done this right out of college, very few of us would even be working today.

The advisor's job is to determine how much exposure to these equities a client should maintain. A younger person may want 100% exposure, while a retiree who is taking regular withdrawals may want a much more conservative exposure. One of the problems with this approach is that the S&P is a poor proxy for the entire global market, so holding this position and no other is essentially shorting the rest of the investment world.

The Target Asset-Allocation Approach
The realization that large U.S. stocks do not represent the entire investment world led to the academic research of the late 1960s and the development of modern portfolio theory. This theory, which is the basis for the Uniform Prudent Investor Act, emphasizes diversification. Adherents to this philosophy believe that exposure to multiple asset classes offers the best combination of volatility risk and expected return.

Using whatever process they have, advisors will determine the proportionate exposure to these various asset classes they want to have in a portfolio, then they capture that exposure using passively managed funds. This approach is also popular with advisors who favor actively managed funds or even individual securities, but their underlying costs will be higher due to their higher management fees and trading costs. That doesn't mean they can't be successful, just that they have a higher cost hurdle to meet out of the starting gate.

Some of these advisors will maintain a market-neutral weighting to the various asset classes, meaning that they hold them in the same proportion that they are represented in the total market. For example, REITs make up about 3% of the total U.S. market, so a market-neutral advisor would hold a 3% exposure to REITS in their portfolios. Other advisors desire a tilt toward one asset class over another. A common tilt is toward value stocks or toward small-value stocks based upon research showing that these asset classes may deliver increased expected returns over long time horizons. Most advisors who lean toward a targeted asset-allocation approach will rebalance back to their targets periodically, but usually do not change their actual targets much from year to year.

The Tactical Asset-Allocation Approach
The advisors who feel uncomfortable maintaining a static allocation to an asset class in the face of "clear" market cycles use a more tactical approach.

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