An advisor’s perspective.

The word “active” certainly has a much more positive connotation than its counterpart, “passive.” But when it comes to investment management, we in the financial-services arena use this terminology thinking that our clients understand the meaning behind this jargon. It is my contention that few investors really appreciate the significance of these terms because we do a poor job describing them in ways in which they can relate.

As an advocate and practitioner of active management, I will share a couple of ways I have found most successful to communicate the rationale and benefits of active management. First of all, active management has become the term du jour. It has become a hot buzzword. Because so few investors know its meaning, financial advisors can profess to use an active investment-management approach without being called on it or having to prove it.

The first thing that I do when I describe active management is describe passive management and how they differ. Besides investing in an index, passive management assumes that no one can really beat the market over an extended period of time. It also assumes that the correlation of certain asset categories will remain fairly uniform over time. Based on these two fundamental assumptions, a strategic but static model is proposed that incorporates a variety of “style box”-type investments. In making allocations, the model is virtually the same in all market cycles and doesn’t evaluate risks in real time.

Passive investing is like using a weather almanac rather than a current forecast to determine what clothing to pack for a trip.

Active management, on the other hand, evaluates current risks and stages within market cycles in order to make more timely allocations. I describe this distinction using weather analogies. Passive investing is like using a weather almanac rather than a current forecast to determine what clothing to pack for a trip. In packing, it would not make sense to rely on the almanac because the almanac is a long-term forecast based on averaging years and years of data. For example, the almanac might indicate that weather conditions in Manhattan in July would be sunny and humid with temperatures during the day reaching 85-90 degrees. However, a current five-day forecast could track a big storm moving into the area with unusually cold and wet conditions.

Just as I wouldn’t pack my suitcase with clothing based on the almanac, I do not think it is wise to allocate an investment portfolio based on long-term historical averages, ignoring current “weather conditions” in the market such as trends, breadth, volatility, or risks of loss.

Howard Marks of Oaktree Capital advises, “Never forget the six-foot tall man who drowned crossing the river that was five feet deep on average.” Passive investing deals with data based on averages, and it allocates based on those averages. The problem is that very few years follow averages. Moreover, averages ignore the impact of large losses, and the challenges and difficulties associated with making up those losses. Minimizing drawdowns is arguably much more critical than capturing all or most of the upside. Current economic and geopolitical factors enhance risk and the likelihood and magnitude of drawdowns, but are ignored and marginalized by passive investors.

Because passive investing deals with averages, and over extended periods of time markets tend to move in a northern (positive) direction, passive investing typically recommends allocations from a long-only perspective. All investing is essentially a bet. Long-only investors bet that the value of an enterprise or indexes in which they are investing will increase. Current stages within market cycles, P/E ratios, technical factors, and sentiment all impact the overall investment climate and whether the changes in that value are likely to move north or south in the foreseeable future.

This data and other factors are usually modeled by active managers to determine whether to make trades in real time and/or how to size the trade. By using this data rather than relying exclusively on long-term averages, the active manager might conclude that the overall market or value of an enterprise is overly extended and therefore ripe for a pullback. In reaching this conclusion, the active manager analyzes a larger universe of investment opportunities, and, for instance, might allocate to inverse investment strategies, which typically increase in value when the market decreases in value.

Clients appreciate how active management navigates all market conditions.

“Buy and hope” or risk management?

No one bets regularly and wins every time. The image that comes to mind when I think of betting, and what I portray to clients, is a roulette wheel with both red and black markers. Very few would bet by putting all of their chips exclusively on black or exclusively on red all of the time. They would most likely divvy them up or vary their pattern in recognition that no one color would come up forever. Passive, long-only investing to me is akin to putting all of our chips on just red or just black during all market conditions.

See Related Article: ‘Buy and hope’ investing versus active management

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

Greg Gann is a registered representative with, and securities are offered through, LPL Financial. Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not protect against market risk.

This article first published in Proactive Advisor Magazine on July 24, 2014, Volume 3, Issue 4.