Wouldn’t it be nice if you could just put your money in an investment account and go about your merry way? After all, you already expended some effort to earn the funds in the first place – shouldn’t they be able to work for you now, without any more stress and strain on your part? Alas, that’s not the way the investing world works. First, you invest it, then you manage it – or you manage the money manager. Either way, it's usually a far cry from invest-it-and-forget-it.
There’s another complication to consider: As you age, the way you invest should probably change. The amount of risk you could take on as a twentysomething is likely different than your risk profile as a sixtysomething.
Once you reach retirement you have to think about what kinds of investments you’ll hold. Do you want active or passive products and how does that affect your risk?
Our article on Passive Vs. Active Management within the Fund Management Issues seminar provides all the nitty-gritty details. But here's a quick brush-up on the basics: An actively managed investment product has a person or team of people constantly making changes in the portfolio in an attempt to beat the market. If the S&P 500 is up 3% in a certain year, the manager or management team’s goal is to beat that 3%, and the farther north, the better.
A passively managed product mirrors a stock market index. An S&P 500 index fund, for example, will hold the same products at the same weighting as the S&P 500 – exactly. The only time the fund changes its holdings is when the S&P 500 changes, and those changes often take place automatically. If the S&P 500 achieves that 3% growth, the index fund will have pretty close to the same growth (minus a small amount in brokerage fees).
As an investor, your goal is to achieve the largest amount of growth at the lowest cost while taking on an appropriate amount of risk. Actively managed products are usually more expensive than passively managed, because those managing it have to be paid. If the market was up 3%, and the fund charges 1% in fees, the fund has to have a 4% return just to break even and probably another 1%, at least, to make it worth the risk.
Then there are the costs of of those trades: transaction costs, clearing fees. There are also tax implications. As active managers are constantly buying and selling new holdings for the fund – and, one hopes, earning money along the way – their activity could be triggering taxes that eat away at the profits. An actively managed fund can have considerable headwinds working against it as it tries to beat the overall market.
And beating the overall market is no easy task. Studies show that as many as nine out of 10 large-cap fund active managers failed to beat their benchmark over the past five years. See Active Managers' Market-Beating Claims Debunked.
Does that mean that you should completely avoid actively managed products? Definitely not, but you have to be very careful and choosy. The level of risk is higher and in general you pay more to take on that risk.
It would be tempting to say that passively managed products are the savior of the investing world, but that’s not true either. Yes, it’s easier for passively managed products to return value to the investor because there’s no fee-charging management team – but sometimes those management teams provide value, too.
Say you held a passively managed S&P 500 index fund from January 2007 until January 2009. That was a period of decline for the stock markets. Faithfully mirroring the index, your fund, and you, would have lost 39% of its value. With passive products, there’s no manager there to adjust the portfolio to protect against downside risk. You’re riding the wave of the market and that could be a scary ride, especially during retirement when your investments are probably a major source of your income.
Also, passive products aren’t necessarily the only low-fee products out there. There are actively managed investments that try to hold the line on costs. The Vanguard Group, a leader in low-cost passive investment strategy, now offers actively managed funds that on average cost 75% less than other funds in their peer group; many have outperformed the S&P 500 over the last three years. For more info, see Top Vanguard Funds for Retirement Diversification.
The answer may not lie so much choosing between active and passive products as it does in finding the right balance of each for your portfolio. First, put together a risk profile for yourself, perhaps with the aid of a financial planner. Maybe, after figuring it out, you come up with 75% low-volatility investments and 25% higher risk/reward products.
There are active and passive options for just about every investment type. When you look for products to achieve this weighting, remember that there is only one thing you can accurately forecast: the fees. Look for products with low expense ratios. Then, look at how they’ve performed in the past, knowing that past performance doesn’t assure future performance. If you’re looking at a passively managed fund, compare its performance to its benchmark index. They should be close to the same.
For active funds, compare them to a counterpart passively managed fund (that is, one that holds similar instruments and has a similar aim, like conservative growth). If the active has had a much better return, consider grabbing it; if not – well, why would you pay somebody to manage a fund if the returns were the same or worse than a passively managed fund?
Nobody wants to think about his or her eventual passing, but once you reach retirement age, those conversations have to take place. What kind of portfolio will whichever of you goes first leave to your spouse? Many advisers recommend simplifying your portfolio as you age. If you have mostly managed it yourself, maybe you should rethink: Unless your spouse shares your passion, passively managed products may be more appropriate for him or her to deal with after you're gone (the same holds true if your accounts are going to very young beneficiaries). Otherwise, make sure a trusted professional is in place to take over the management of funds.
There are active and passive products in all investment categories. In general, for an actively managed product to be a better value than a passively managed one, it needs to have considerably outperformed its benchmark after subtracting fees. As with any other purchase, at the end of the day you’re evaluating value – not price.
That being said, there are pros and cons to each type of product. One is not necessarily better than the other. The answer lies in the degree of weight you want to give each among your holdings.