Passive or Active?

Once you have settled on an investment allocation that’s appropriate for you, how do you decide which funds to use?  According to Statista, there are more than 9200 funds in the U.S., and almost 80,000 mutual funds worldwide.  Mutual funds hold more than $31 trillion of assets, with more than $15 trillion of those assets in the U.S.

Our experience tells us that seven to eight funds in a portfolio is optimal.  Fewer than seven funds leads to concentration which can increase volatility.  More than eight funds dampens performance, and does nothing to protect the downside.

The primary debate within the fund community, and to some degree among investors, is whether to use actively managed or passive funds.  After a review of white papers and journal articles discussing all sides of the discussion, we have found that whether actively managed funds outperform their respective indices is a function of the ten year period being measured.

We have chosen to take a two-pronged, or core/satellite, approach to building portfolios, with a focus on passive, low-cost, investments.  Since we don’t know during which ten year rolling period actively managed funds will outperform, we find this approach makes sense for our clients. 

For short term bond, intermediate bond, and domestic large cap investment classes, we choose to use index ETFs, which is a passive, low cost, investment approach.  Index ETFs are attractive to us for three reasons.  First is their low cost, with most index ETFs available at annual operating costs of 0.10% or less.  Two of our favorite bond ETFs are BLV and BSV, both Vanguard products, each with operating expenses of 0.09%. 

Second, for taxable accounts, ETFs give us complete control over the timing of capital gains exposure, since they trade like stocks.  If you have $10,000 in a taxable open-end mutual fund, a 20% year-end distribution, common for open end mutual funds in very good years, is $2000.  This $2000 in taxable income, whether taxed at ordinary or capital gain rates, is unlikely to have a significant impact on your tax bill, cash position, or lifestyle. 

However, if you have $500,000 in the same fund, that 20% distribution represents $100,000 in additional taxable income.  Regardless of the size of your income, an additional $100,000 in taxable income will get your attention, come tax time.  And, this tax reduces your “after-tax” return.  Real return on your portfolio is measured net of taxes, fees, and inflation.  Using an ETF in the same scenario allows all gain to remain untaxed until such time as you, the investor, choose to sell or otherwise dispose of, the position.

The third benefit of using passive ETFs is simply that using a passive approach reinforces the long term nature of investing, and helps reduce the need or desire to search for the last, best, greatest fund.  This continual search for the investing Holy Grail, and its pursuit by continual changes, is harmful to portfolio value and long term wealth accumulation.  Please remember that money is like soap – the more you touch it, the smaller it gets.

Once we have the core of the portfolio built with passive ETFs, we will populate small percentages of a portfolio with actively managed specialty funds.  These might be specific to a sector, such as life sciences or biotech or energy, or specific to a region or country.  Regardless, these satellite funds rarely comprise more than 5% each of a portfolio,, with total allocation less than 20%.

From a tax management standpoint, we have found that clients are best served by holding actively managed funds, when we use them, in tax-deferred or tax-free accounts (IRAs and Roth IRAs).  This allows us to forego worry about the potential tax outcomes which are beyond our control, when holding actively managed funds.

While there are few perfect investment solutions, we have found that a focus on low-cost passive investing, always being careful of tax outcomes, and supplemented with minor positions in specialty sectors, seems to serve our clients well.