A passive portfolio management approach is appropriate for many 401(k) plan participants and individual investors. But indexing isn’t right for everyone. Many investors are not satisfied with market average returns. Nor do they feel it makes sense to lock in 100% of every market decline. Many believe they can consistently outperform market averages by applying a little of the right knowledge. Think there is no point to active management? Consider the following to make active management work for your plan participants:

 

1. Eliminate all closet indexers. Purge them from your portfolio. They never significantly beat their benchmarks and give active management a bad name. This is where excess cost resides in mutual fund portfolios.

 

2. Index efficient asset classes. Use passive management for those asset classes that are efficient – where it is hard for a mutual fund manager to significantly and consistently beat the benchmark. Taxable fixed income is an example of an asset class you may wish to index.

 

3. Hire active managers for inefficient asset classes. These asset classes, where the returns of mutual fund managers can vary significantly, include commodities and international stocks and bonds.

 

4. Defense is good. Consider that some mutual fund managers are really good defenders of your investments. They may not outperform significantly in up markets but may fall much less than market indexes in down markets. Choose mutual funds that have a down market capture rate of less than 100%.

 

5. Full market cycle. A major reason many investors abandon active management is they feel every active manager should beat their benchmark every year. This is unrealistic. Review the performance of all your mutual fund managers over a full market cycle.

 

6. Allocations. Plan participants can use active management to determine their allocations among asset classes.

 

It is unlikely that the next five years in the equity markets will be anything similar to the last five, raging-bull market years. The risk-on, risk-off market conditions we experienced for a number of years immediately after the crash favored an indexed approach. When all risk assets are highly correlated it is hard for active managers to distinguish themselves. Remember when investing we are always fighting the last war – looking back at what has done well, rather than what might work in the future. Will market conditions be as favorable to indexing in the near future? Probably not.

 

Most investors’ portfolios will benefit from a combination of active and passive management. Use active management effectively by hiring a competent investment adviser to help you screen for active mutual fund managers in inefficient asset classes. Be sure to review manager performance over full market cycles and make portfolio allocations based upon your risk tolerance and age. Use an indexed approach for those asset classes which are efficient.

 

Robert C. Lawton is president of Lawton Retirement Plan Consultants, LLC (lawtonrpc.com), an RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at bob@lawtonrpc.com or 414.828.4015.

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