Think of active investing as a complement in your portfolio.
Active investing can complement portfolios that are mostly invested in mutual funds or exchange-traded funds and are based on benchmarks. Active management does not add a lot of value in situations where the portfolio manager is expected to “hug a benchmark like the S&P 500,” says Charles Sizemore, chief investment officer of Sizemore Capital Management in Dallas. “If you’re wanting index exposure, it’s cheaper to buy the index fund and be done.” Active management will add value when a portfolio manager’s strategy is minimally correlated to the rest of your portfolio or in situations where investors have specific risk-management needs, Sizemore says. Investors could allocate 20% or more of their assets to active investing, but only when the active strategies are minimally correlated to the rest of the portfolio, he says. Other financial experts advise investing 10% to 15% to active management.
Here are 10 reasons why investors should add active investing to a portfolio.
Pursuing uncorrelated returns from other asset classes.
Active trading allows investors to seek uncorrelated returns from other long-term investments and can help diversify assets, says Travis Gatzemeier, founder of Kinetix Financial Planning in Flower Mound, Texas. Investors who use active investing can take advantage of market momentum and extreme moves one way or another, says Timothy Seymour, founder of Seymour Asset Management in New York and portfolio manager of Amplify Seymour Cannabis ETF (ticker: CNBS). “You can identify extreme positioning — great companies can be overbought or oversold from earnings or other events,” he says. “Active investing gives you opportunities to add or take off exposure in either direction.” Active portfolio managers also do not need to wait to rebalance assets until the next quarter and have more immediate accountability, Seymour says. “The manager can cash in that stock and truly be able to react to market events or corporate governance issues.”
Getting cheaper access to some stocks.
Mutual funds often require a minimum investment of $3,000, while some target-date funds require an investment of at least $1,000. Buying a partial share, otherwise known as fractional investing, can give the investor exposure to a company, a sector or strategy slowly over time. Interactive Brokers was the first brokerage to offer fractional shares in 2016, has the largest inventory and was the first one to offer the capability to registered investment advisors, according to the company. Investors can access fractional shares through its robo-advisor, Interactive Advisors. For $100 you can get up to 1,000 stock slivers — including environmental, social and governance portfolios.
Gaining exposure to bonds.
Investors can add fixed-income assets via actively managed bond and commodity funds, says Daren Blonski, managing principal of Sonoma Wealth Advisors in California. Portfolio managers can assess the holdings in a bond fund during uncertain economic periods and divest any holdings with weak growth potential. Municipal bonds are likely to underperform in 2020 and beyond because many state coffers have been depleted due to the pandemic. “Certain states and cities are more likely to stay fiscally sound, and an active manager will know how to make a proper assessment and know if there is a solvency issue,” he says. “There are patterns in the market, and if you’ve been in it long enough, you know what they are.”
Seeking thinly traded stocks.
Active management may make sense in certain thinly traded or low-volume areas and in micro-cap sectors of the U.S., says Derek Horstmeyer, an associate finance professor at George Mason University in Fairfax, Virginia. “Here we actually see a few managers having consistent results in beating the market over time,” he says. “In the large-cap area, actively managed funds don’t make too much sense since passive funds tend to outperform most after the expense ratio is figured in.” The smaller or more illiquid a sector, the more value active management offers, Sizemore says. “If it can be indexed away, an active manager will offer a lot less value.”
Capturing volatility in the market.
Active investing helps investors take advantage of the moves in the market, says Jason Spatafora, co-founder of marijuanastocks.com and head trader at truetradinggroup.com. “By staying active in your portfolio during the current state of the market, you can take advantage of market volatility by selling high and buying lower using a percentage of the holdings,” he says. Active management plays an important role in managing risk and in its ability to take advantage of market inefficiencies or perceived mispricings among securities, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional. “This is especially true in times of high volatility and dispersion,” she says.
Investing in small caps or international stocks.
The advantages of index investing far outweigh any advantage of active investing due to lower turnover, higher after-tax returns and lower expense ratios for index funds, says Stuart Michelson, a finance professor at Stetson University. The lower expense ratios of index funds can provide a 0.5 to 3% advantage in overall returns. There are a few areas where actively managed funds appear to outperform the index, including small-cap and international stock funds, which can more specifically target attractive investment opportunities such as certain countries, he says. On an annual basis, actively managed funds appear to perform better than index funds during recessionary periods, Michelson says. Active management can pay off in segments of the markets that aren’t as widely followed such as small caps and international equities, says Mike Loewengart, managing director of investment strategy at E-Trade.
Adding value stocks.
There is evidence of the opportunity for value managers to greatly outperform their benchmarks, Gunzberg says. Some sectors may be more divided now based on winners and losers from the pandemic, including real estate, travel and entertainment, energy, health care, and consumer discretionary. “Active managers may exercise skill over a larger opportunity set in less efficient asset classes,” she says. Value stocks are fertile for active managers, especially in U.S. large caps since the active component “goes beyond picking stocks, but includes managing risk from potentially large weightings in market-cap-weighted benchmarks,” Gunzberg says. “Now we also see many opportunities for active management in U.S. small-cap equities as well as in high yield and corporates that all require quality for their premiums.”
One benefit of active trading is risk management, which is the ability to quickly change a portfolio’s exposure to a specific sector or market when conditions change, says Anthony Denier, CEO of Webull, a New York-based trading company. Active traders seek to beat the market or obtain alpha, which is a profit above a benchmark index’s annual return. “This is also a great way to take advantage of short-term trading opportunities,” he says. Managing risk is a function of managing assets in a way that provides the broadest level of diversification, Blonski says. “Diversifying a portfolio allows for more consistent returns, less volatility, and the assets perform better across different market conditions,” he says. “Stocks that did well yesterday won’t always do well tomorrow.”
Capturing upside in sectors like marijuana.
Portfolio managers in actively managed ETFs can divest troubled marijuana companies when there are financial or corporate governance issues, Seymour says. Investors have to actively trade in cannabis because the industry is changing so quickly with different variables impacting stock prices, he says. “When capital markets and traditional forms of financing are not normal, and it’s a difficult environment, we invest in companies that have proven they can operate in this environment,” Seymour says.
Hedging against passive investing.
The key reason investors want to have some exposure to active management is as a hedge against market-cap-weighted indexes like the S&P 500. A handful of stocks make up almost a quarter of the weighting in the S&P 500. “If/when those stocks (which are tech-heavy) take a breather, you will have the benefit of a good active manager that has anticipated the sector rotation and put you in stocks set to outperform on a relative basis,” says Thomas Hayes, chairman of Great Hill Capital in New York.
Why investors should add active investing to a portfolio:
— Pursuing uncorrelated returns from other asset classes.
— Getting cheaper access to some stocks.
— Gaining exposure to bonds.
— Seeking thinly traded stocks.
— Capturing volatility in the market.
— Investing in small caps or international stocks.
— Adding value stocks.
— Managing risk.
— Capturing upside in sectors like marijuana.
— Hedging against passive investing.
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Why Investors Could Add Some Active Investing to a Portfolio originally appeared on usnews.com