The Benefits of Active Investing
Investors are faced with two competing investment management approached. Active management, whereby a portfolio manager selects securities based on analysis and outlook of the risk and return profile and the client’s investment objectives, with the additional goal of trying to beat the market index. And passive investing, which seeks to track a market index, but at a lower management fee.
The Flexibility of Active Investing
Active investing allows a portfolio manager the to sidestep the pitfalls of passive investing and avoid over-concentrated positions that may exist within an index. A portfolio manager has the flexibility of selecting which stocks to own and what weight each stock will represent in the overall portfolio. This approach has proven to be valuable in ensuring that portfolios remain well diversified and can preserve capital in periods with market disruption. An example of this would be Nortel Networks Corporation. At its peak in 2000, the company represented over 35% of the value of TSX index. For a period of time, as Nortel went up in value so did Nortel’s dollar value in the index, but ultimately, when the company became worthless passive investors were exposed to significant losses.
Another advantage with active investing is the ability to adjust the risk profile of a portfolio with the evolution of the business cycle and market events. Active investing allows a portfolio manager to change the allocation between growth and capital preservation assets. If needed, an active investing portfolio manager can also minimize downside risk by shifting from growth stocks to defensive or income producing stocks.
Financial Planning Advantages with Active Investing
Active investing also allows for a direct opportunity in tax planning in the form of tax loss harvesting. This is something that is less easy under passive investing. For example, in an actively invested Canadian portfolio, a manager typically has multiple stocks that they can chose from to trigger capital losses in order to minimize taxes by offsetting them against capital gains. With passive investing, that same individual will hold one index ETF that does not offer the direct ability to trigger any losses from the stocks held within the Canadian index ETF. An active portfolio also allows the manager to realize capital gains needed to offset prior years’ losses or excess medical tax credits.
Active investing also allows for the possibility of structuring a portfolio for specific investment goals. For example, retirees typically have income and preservation of capital as goals. An actively invested portfolio manager can structure the portfolio in such a way that it holds income producing securities with stable cash flows whereby capital can be preserved. It should be pointed out that there are passive investing ETFs with the goal of producing income. However, these income ETFs may hold income producing stocks in which their dividends are unsustainable in the long term whereby jeopardizing the secondary goal of preservation of capital.
In the end, active investing provides a greater value proposition to investors. This is because active investing portfolio managers can provide financial planning advice and discipline tailored to your circumstances. Moreover, they can also avoid the presence of existential shocks to the markets and the existence of highly concentrated positions associated with index investing. For this they charge a fee, but this may well be worth the additional tax-deductible cost.