Given the choice, many investors would love to invest their money, set it, and forget it until retirement. Safe in the knowledge it would always be growing at a nice, steady pace.
As we know, life has a tendency to throw us (and our investments) curveballs—one of the biggest in recent times was the global financial crisis. But these are teachable moments and thoughtful investors have come to realize that one type of investment strategy—whether active, passive, or something in between—is unlikely to hold the key to all of their investment needs.
Making investment decisions and choosing investment strategies based on a very narrow set of parameters can result in a far from optimal solution. For example, over the last decade and more, passive investing has grown in popularity, fueled by a focus on two key variables: relative performance (the ability of an active manager to beat the benchmark index) and cost. When active managers were unable to consistently beat the index, investors opted for passive management of the asset exposure as a more cost-effective option.
As important as performance and costs can be, the financial crisis also helped investors realize the need to evaluate their investment choices through a much broader lens. In particular, they came to recognize that:
- Achieving personally defined outcomes matters more than meeting a market benchmark.
- There is a better chance of achieving personal outcomes using holistic investment solutions than individual products.
Is it Really Active or Passive?
Since real-world outcomes are unique to each individual or organization, it’s impossible to make a single statement that applies equally to every investor. But we believe we can say that:
- In today’s challenging market and return environment, investors need as many options in their investment toolbox as possible.
- Achieving real-world outcomes using entirely passive strategies (which primarily concentrate on delivering beta) won’t necessarily get you where you need to be.
- For most investors, that means using active and passive strategies, rather than solely one or the other. The lower fees associated with passive investing aren’t enough of a reason to abandon active investing if it can mean leaving additional alpha potential on the table.
When to Use Which Strategy
If both active and passive strategies have a role to play in achieving personally defined outcomes, what determines which strategy an investor should use and when?
It makes the most sense to use active investment management in asset classes where it is proven to have a distinct advantage over passive management. These alpha sweet spots are typically “inefficient” asset classes that are more specialist in nature (e.g., international equities and international small-cap equities) than core asset classes (e.g., U.S. large-cap equities). Core asset classes tend to be more efficient, making it more difficult for an active manager to add value, and making passive management of the asset exposure a (likely) more cost-effective option. In contrast, talented active managers would be expected to find greater opportunities in specialist asset classes to produce excess performance over the benchmark. More specifically, however, empirical evidence shows that not only can the average active manager add significant value, but the outperformance of top-quartile managers could safely cover any management fee two or three times over.
We believe this evidence, documented in our new white paper The Wisdom of Staying Active in an Outcome-Oriented Investment World, confirms our conviction that in the hands of the right manager, an active investment strategy not only pays for itself but can make a material financial difference to a portfolio. That makes it an essential tool to help navigate and achieve personally defined investment outcomes.
Investing involves risk, including possible loss of principal.
Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.
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