by Mark Neil

On the whole most portfolio managers are pretty dull people.  They are highly analytical and tend to enjoy the company of company financial statements and cash flow projections rather than every-day, run of the mill people like us.  To be really good at what they do they have to be like that.  It’s a requirement of the position, one of the very first things listed on the job description.  When they are not studying financial statements they are talking to company executives.  They spend hours on the phone talking to them trying to pry out a tidbit of information that may give them an edge when deciding whether to purchase that company’s stock or not.  

Some of them spend lots of time with computers trying to build that magic computer model that will digest company and market data and then spit out a list of the best stocks to buy.  The quest for that model is a never-ending search, sort of like Ponce de Leon and the Fountain of Youth.

There are many ways to label portfolio managers.  They might be a value manager or a growth manager.  Some managers use technical tools like charts, graphs, wave analysis or other statistical tools.  Then you have managers who do bottom-up analysis while others prefer the top-down approach.

It is useful to understand those labels because it gives you a little insight into how the manager thinks.  After all if they are going to manage your money, shouldn’t you know something about how they think?

If none of these labels makes any sense to you don’t despair.  There is another little secret that you need to know about investing and it has nothing to do with the manager’s preferred style of investing.  That little secret is more important than most of what these fine individuals spend their time pursuing.  I will share that secret with you at the end of this column

Active vs. passive.

One of the major label question in investing has to do with whether you are a passive manager or an active one. Passive managers like to purchase stocks that make up the various indexes such as the S&P 500 or Nasdq and hold onto them.  With this strategy they will have lower expenses and be able to generate returns that mimic the market averages over the long haul.  Active managers on the other hand prefer to search out the better performing stocks and buy and sell at the right time, thereby creating better than average profits.  As you can see there are stark differences in these approaches.  When presented with the opportunity to debate the relative merits of these two methods, these dull, analytical math whizzes can suddenly turn in to bombastic, pontificating zealots.  Given the right venue, they can make the WWF look like a schoolyard shoving match.  

You can get these fireworks started on your own the next time you are talking to a couple of portfolio managers.  Just ask them which method is best, active or passive. You don’t need to do anything else but stand back and watch the fur fly!  

The dialog will go something like this:

Passive Manager, “Over the last 10 years the passive index (S&P500) was in the top 18% of the large cap management universe.  Therefore 82% of the active managers under-perform the market averages.”

Active Manager, “If the purpose is to outperform the averages, why not find and hire those managers who were ahead of the index?”

Passive Manager, “Well you certainly could, but you have to factor in expenses as well.  Any expense of the fund will reduce the overall return and push you closer to the average.”

Active Manager, “Nonsense.  It is obvious that low expenses do not matter because of the funds that outperformed the average over the last 10 years, only 19% of those had expense ratios less than 0.50%.  What is important is not how much you pay in expenses, but how much you have left over!”

Passive Manager, “You have just proven my point about expenses.  Of the 36 funds that outperformed the market over the last 10 years, 91% of them had expenses below the category average.”

Active Manager, “No, you have just proven my point!!  Some of the top performing funds over the last 10 years have expense ratios that are 20-40% higher than the average expense ratio!”

Passive Manager, “Surely you are familiar with Bill Sharpe’s simple treatise on the mathematics of active management.  He proved with simple math that since all investors together equal the market, the average dollar invested in active management will equal the return of the market less expenses.  He won a Nobel Prize for that theory.”

Active Manager, “Big deal!  That is exactly why you should not select average managers.  Look at Peter Lynch’s record with the Magellan fund!  Besides everyone knows there is more money under active management than passive.  That should be enough proof which is the better method.”

See what I mean?  You have two opposing sides debating the same argument using the same data.  This debate has been going on for over 20 years and the poor individual investor is caught right in the middle.  No matter which methodology they choose to pursue, the opposite side will continue to present them with very compelling statistics that will cause them to abandon their approach to investing.  A worse case is the individual investor who is in constant conflict as they read about or listen to the “experts” on the other side of the argument.  That is not a healthy situation to be in.

The clouds part and a shaft of light descends.

Now allow me to let you in on that little secret I promised at the beginning.  It doesn’t matter whether you are active or passive with your investments.  People don’t fail financially because they choose one over the other.  

They fail because they do nothing!  

They fail because they sit on the sidelines wringing their hands in despair and wondering what they should do.  Should they buy the S&P500 or should they hire Peter Lynch? It doesn’t matter.  On a long term basis the difference between the two strategies is measured in fractions of percentage points.  Begin investing today, continue tomorrow and the day after.  The returns, expenses and all that other stuff will take care of itself.  

If you do that in 20 or 30 years you can be sitting on a beach somewhere with one of those drinks with the little umbrella in it and laughing at that same argument that has been going on now for 50 years!

Contact Mark Neil at:
Northwest Wealth Advisors, Inc 
0605 SW Taylors Ferry Road
Portland, OR 97219
Office: (503) 478-6632 
Fax: (503) 595-1863 
Email: mneil@nwwealtadvisors.com 

© 2003 Mark Neil