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Weighing the pros and cons of active portfolio management

While passive fund flows keep booming and actively managed fund flows keep dwindling, according to recent research from Bank of America Merrill Lynch, advisors are still mixed about using active or passive strategies for portfolio management.

Ken Graves, chief investment officer of Capital Research Advisors and president of the National Association of Active Investment Managers, defines active management as "having a process and procedure for how we continually invest money."

"We have very mechanical, math-driven systems and don't count on a single model," he added. "We use strategies that don't correlate with each other and work to keep the portfolio within a risk range."

Active and passive management
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NAAIM board member Steven Williamson, owner of options trading firm Legacy Investment Group, adds that active managers trade often, from 10 times a year to 10 times a day.

"We differ from [passive-focused managers] in that they typically leave clients in securities for years or decades," he said, referring to those who buy and hold and/or use passive index funds.

"There are two ways to mitigate risk," Williamson said. "The active manager moves funds as needed to limit losses by strategy, and the [passive] asset-allocation [proponents] who buy and hold, assuming that one asset class rises when another one goes down."

Active 'cons'

Actively managed funds most times will not overperform the market, said Herb White, certified financial planner and president of Life Certain Wealth Strategies. He added that actively managed funds are not as tax-efficient with non-qualified retirement funds.

"You are never going to be No. 1 in any short-term period, because of a diverse portfolio," said Larry Luxenberg, CFP, managing partner and chief investment officer of registered investment advisory firm Lexington Avenue Capital Management. An approved advisor with Dimensional Fund Advisors, Luxenberg is a strong proponent of passive management.

"But over time you're likely to be in the top ranks of returns," he said. "If you're out of the market, you won't participate in declines or the upside."

Luxenberg, who had been in active investing for many years, suggested several disadvantages to active management:

  • Trading eats up gains.
  • The typical active investor is not as diversified, which often leads to inferior returns.
  • Typically active managers hold more cash than do passive managers, which hurts returns.
  • Many active strategies are not necessarily appropriate for the retail investor.

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"There's no evidence that active management avoids the downside," Luxenberg said. "I don't see any need for complicated strategies.

"Going back to 1926, by participating broadly in the stock market, your money should double every seven years on average."

Active 'pros'

In response, Graves of Capital Research Advisors said that "with passive management, you maintain an allocation for the long term, but the problem is that the market is agnostic to your needs."

"If you buy into funds during up markets, you don't have the flexibility to buy at a better opportunity," he added. "Most of us do have the discipline or time to implement some strategies."

Diversification did not matter in 2008, Graves said, because we are now in the third year in a row with single-digit returns.

"Sitting on some cash has allowed you to avoid market losses," he said. "Trading is super-cheap today, and as for spreads, you need to know how to work the trade.

"Active management creates a situation where you can avoid damaging downturns in the market and capture most upturns."

"I don't think there's one right strategy to follow. Passive management works well when markets are rising, and active management works well when the market is choppy and you want to invest in different sectors." -Herb White, president of Life Certain Wealth Strategies

For his part, White of Life Certain Wealth Strategies said that "when you're up against a situation like Enron, you're stuck when you're doing passive management."

"But with active management, you are not forced to own it," he added.

In fact, more than 75 percent of advisors surveyed by Cerulli Associates agree that in volatile markets, active managers can offer downside risk protection through tactical trading, according to "The Cerulli Report — U.S. Advisor Metrics 2016: Combating Fee and Margin Pressure."

"There are two ways to generate growth: Make more than the market, and lose less than the market in down cycles," said Edward Kohlhepp Sr., CFP, president of Kohlhepp Investment Advisors. "Active-management proponents say they can do the latter.

"It's a smoother ride for the client and easier to stay the course," he added. "We have found that most investors cannot tolerate a major correction psychologically.

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They would rather limit their downside, unless they are just starting their careers, Kohlhepp said. "People's psychological profiles change when the market changes."

There's a place at the table for both approaches, said White of Life Certain Wealth Strategies.

There are different ways to do active management, whether through funds or buying specific stocks. Likewise, passive management can be done through passive ETFs, he said.

"I don't think there's one right strategy to follow," said White. "Passive management works well when markets are rising, and active management works well when the market is choppy and you want to invest in different sectors."

— By Deborah Nason, special to CNBC.com