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Are You a Good Stock Picker? Matthew Clay, Managing Director, JRWA
Financial Advisor, RJFS
September 2017

Some market analysts have suggested that the greatest revolution in investing is the advent and rise of low-cost passive investments – particularly mutual funds and ETFs (exchange traded funds). Every year more and more capital is flowing into passively managed investments which now makes up over one third of the assets in the U.S. What is the difference and more importantly, why should I care?

Passive Investments

Passive investments are designed to track a particular benchmark or index. The Standard and Poor’s 500 Total Return Index is a popular benchmark for large capitalization US stocks. Typically, as the companies or constituents in the index changes, so does the fund that is tracking it. Passive investments tend to have relatively low turnover without a lot of buying and selling in the portfolio. They don’t pay for research staff and investment professionals to try to uncover value creating opportunities through fundamental research of quantitative modeling. Less oversight and trading leads to lower costs. They are also very transparent. Typically, whatever is in the benchmark is in the fund. This long-term approach to buy and hold with limited trading activity helps to contribute to increased tax efficiency. These funds also tend to operate within their stated universe. Essentially, these funds are limited to a predetermined index or set of investments. However, there is also one universal truth about passive investments – they will typically underperform the market. Even if costs are low, passive funds may underperform their respective indexes and benchmarks.

Active Investments

Contrastingly, active investing is usually very hands on in an effort to find stocks (or other investments) that when put together in a portfolio has a chance to outperform the market benchmark. Active managers typically have greater flexibility in their selection of investments as they are not constrained to a specific index. They can engage in hedging activities to reduce risk. Active managers provide an opportunity for more specific tax management strategies. All the research, marketing, technology, and cost of investment in professionals come at a cost. Actively managed investments are usually higher in cost than passive investments.

A prevailing argument in the industry is that active managers, after accounting for their costs, typically underperform their benchmarks. While certainly some individual active managers have at times exhibited skill in outperforming their benchmarks, most studies on the matter have suggested that generally they fail to outperform their benchmarks. It should be noted that most of these studies have focused on the performance of active stock managers and there is less rigorous academic research on bonds and other investments.

At Jackson/Roskelley Wealth Advisors, we believe that clients benefit from strategies that utilize both active and passive investments. Some of you may have heard of while others may be unfamiliar with a term called the Sharpe Ratio. This is a financial measurement that calculates a ratio of return relative to risk. The Sharpe Ratio describes how much extra return you could receive relative to the amount of risk you are taking. Simply, the concept states that one should expect to earn higher returns for taking on more risk, and the Sharpe Ratio attempts to provide a risk-adjusted measure of an investments performance. Earning 10% instead of 8% isn’t necessarily a better outcome if the investor took on much more risk on an adjusted basis to earn that return. We try to build investment portfolios with strong risk adjusted returns.

Our portfolio construction process is based on a top down approach. We first evaluate the mix of asset classes we want to utilize. Stocks (equity), bonds (fixed income), and real assets (commodity, real estate, etc.). Then, we look at sub-asset classes or sub-sectors as illustrated below:

Next, we make choices about style including value, growth, or blend and other sub-styles including momentum, trend, etc. We screen and evaluate thousands of investment options to ensure our selections are designed to invest within their respective universe. Additionally, we make determinations on whether we want to utilize an active or passively managed investment for any sub-strategy within the portfolio. We often employ another financial measurement tool in helping us with this determination. We utilize something called the Information Ratio. The Information Ratio measures an active manager’s ability to generate extra return relative to a stated benchmark. The Information Ratio is similar to the Sharpe Ratio except that rather than just simply measuring the risk-adjusted return it is measuring that return in relation to a benchmark or index. Our experience over several decades, and statistics across various markets, suggest that some types of investments, including some sub-asset classes have higher information ratios than others. For example, international developed equity and emerging markets equity tend to have higher Information Ratios on average than that of US Large Cap equities. This means that, statistically, it is incrementally more difficult for actively managed large cap US equity investments to outperform their stated benchmarks than it is for an emerging markets equity manager to outperform theirs. Just because a particular sub-asset class or style has a higher Information Ratio doesn’t mean that it will necessarily mean that it will out-perform the benchmark and therefore an actively managed investment approach should be used. Rather, it means that, by comparison, there is an increased opportunity for actively managed investments to outperform or generate alpha relative to their benchmark.

Intuitively, this makes sense. There is a significant amount of data and information on large publicly-traded companies in the US stock market. There are often hundreds of analysts and even hundreds of investment firms performing due diligence and research on these companies. In the age of the internet, the most up to date and relevant information is available almost instantly. Therefore, one could argue, that this level of information creates a certain amount of efficiency that makes it increasingly difficult for an active manager to outperform the market – more difficult but not impossible.

When it comes to bonds or other assets and very similar thought process should be considered. For example, there is only one Ford stock. The ticker is “F”. However, at any point in time Ford may have hundreds of bonds they have issued outstanding. This is not only true for corporations but governments and municipalities as well. When one considers that the global bond market is about 7 times larger than the global stock market, it is not surprising that often careful consideration is necessary in selecting the appropriate fixed income allocation and investments. Bonds have a variety of important characteristics to consider and each and every bond has certain characteristics and nuances which may make it more or less suitable for an investor’s portfolio. At Jackson/Roskelley Wealth Advisors we believe it takes more skill to manage a portfolio of corporate credits than to manage a portfolio of US treasury bonds. This is one example, of how we might choose to utilize an actively managed strategy versus a passively managed strategy.

Parting Thought

Considering the pros and cons of both active and passively managed investments, we believe investors are best served through a diversified approach. Depending on the underlying investment strategy, a combination of both active and passive investment styles, across a range of asset classes and sub-asset classes, enables us to construct investment portfolios that are not only well-diversified but also are constructed with a focus on improving risk-adjusted performance outcomes. So, while the debate regarding passive versus active rages on, our clients can be assured that we personally take a very “active” approach to understanding our clients’ needs and investment objectives and developing strategies and solutions to help them reach their goals.

Views expressed are not necessarily those of Raymond James & Associates and are subject to change without notice. Information contained herein was received from sources believed to be reliable, but accuracy is not guaranteed. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Diversification and asset allocation do not ensure a profit or protect against a loss. There is no assurance that any investment strategy will be successful. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification. Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha." There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices rise.

In a fee-based account, clients pay a quarterly fee, based on the level of assets in the account, for the services of a financial advisor as part of an advisory relationship. In deciding to pay a fee rather than commissions, clients should understand that the fee may be higher than a commission alternative during periods of lower trading. Advisory fees are in addition to the internal expenses charged by mutual funds and other investment company securities. To the extent that clients intend to hold these securities, the internal expenses should be included when evaluating the costs ofa fee-based account. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing their needs. These additional considerations, as well as the fee schedule, are listed more fully in the Client Agreement and the Raymond James & Associates Wrap Fee Program Brochure & Brochure Supplement for Ambassador or the Raymond James & Associate's Form ADV Part 2A & Brochure Supplement for Passport.

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