Blending of the Best of Active and Passive

By John Reese (@guruinvestor) —

(interested in Validea’s investing system and guru models? learn more about this webinar)

Like most things in life, investing in the stock market means different things to different people and encompasses a wide array of approaches—along with an endless supply of debate regarding which may be the best. There is no one-size-fits-all strategy, and every investor should follow a methodology that aligns with their financial goals and unique level of risk appetite.

Here are some thoughts regarding various investment approach options:

Active versus passive investing debate

Active investing, also referred to as “stock-picking” involves the individual selection of securities by an investor or portfolio manager. Passive investing, an approach in which investors buy a broad cross-section of the market and weight holdings based on market capitalization, is a rules-based, disciplined strategy that strives to obtain the same return as the broader market. Investors’ growing exodus away from active and into passive has been dramatic (to the tune of $1 trillion over the past decade), driven by both the lower cost and historically better performance of passive funds. Still, the lion’s share of invested dollars is actively managed (upwards of $10 trillion), and there is heated debate around whether the cost-benefit arguments against active investing are well-founded.

Although there is an undercurrent running through the investment community suggesting that active stock-picking is at the root of many investor ills (and one that has robbed them of returns), I would argue that the debate is more gray than black and white. Each approach presents a continuum of strategies available to investors that can be used in a wide range of combinations. Clearly, if an active approach involves buying a stock because it’s performing well at the moment or is the subject of exciting media buzz–this can be a risky proposition, but there are other types of stock picking that can be less risky. Choosing stocks based on proven strategies and underlying fundamentals, for example, can increase an investor’s odds of enjoying outperformance over time.

Human versus quant investing debate

Fund managers continue to allocate resources to quantitative modeling in the hopes of beefing up returns, satisfying prickly clients and maybe even attracting some new ones. The flow of funds into the “quant” sector has more than doubled since 2009, and high-profile managers (BlackRock, for one) are bulking up their quant teams and relying more heavily on computer algorithms for stock-picking. But there is nothing magical about quant strategies. If anything, they’re the opposite of magic. Models are built, numbers are crunched, and the outcomes trigger buy/sell decisions. Maybe an oversimplification, but the approach constitutes a safety in numbers approach, with the bonus of removing any emotional response that a human might inject into the process. But the models are only as good as the humans who build them, so a strong quant team will keep its models flexible to avoid derailment when abnormal market events inevitably occur.

So, while human error and emotion can be a recipe for investment disaster, putting blind faith in computer-based strategies isn’t prudent either.

The case for a blended approach

At Validea, we use an investment approach that draws from both active and passive strategies through stock screening models we constructed based on the philosophies of such investing greats as Benjamin Graham and Warren Buffett, among others. The table below highlights some of the differences and similarities between a fundamentally inspired, rules-based strategy such as the ones we run here and a passive investment strategy similar to how the S&P 500 or Russell 2000 may be managed.

Validea approach Traditional passive investing
Fundamentally weighted based on guru strategies Market-cap weighted, favoring largest firms
Rules-based and disciplined Rules-based and disciplined
Owns only the best stocks according to our models Owns all stocks in marketplace for pure market exposure
Potential to outperform market Matches overall market performance

Of course, the fees associated with passive investing offer investors a huge cost saving advantage over expensive actively managed strategies. Investors, more than ever, are paying attention to fees and asking themselves if they are getting value from the managers or strategies they are invested in. Finding cost effective, fundamentally sound strategies that combine elements of both active and passive approaches can be the best of both worlds– and are definitely worth considering when establishing or reviewing your investment portfolio.

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John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Follow John on Twitter @guruinvestor