How Fiduciaries Combine Active And Passive Management in Client Accounts

Advisors adhering to the fiduciary standard typically gravitate toward index funds or other passive strategies such as those developed by Dimensional Fund Advisors, Vanguard and others.

There’s a good reason for that. As fiduciaries, these advisors put client interests ahead of their own. Among other things, that means not taking commissions to sell investment products.

However, a fiduciary isn’t required to use only passively managed or index funds. In fact, there are situations where actively managed funds make sense in a client portfolio or may be the best alternative, given the circumstances.

“As a fiduciary, one of the reasons for combining active and passive management is we are obligated to bring all options to clients and recommend strategies that are most appropriate for their situation,” says Faron Daugs, founder and CEO of Harrison Wallace in Libertyville, Illinois, who uses both active and passive strategies in client portfolios.

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This combination introduces distinct investing disciplines, which Daugs says can help mitigate risk. “From a fee or a cost perspective, passive management is generally less expensive than active. We can keep the fee structure down by incorporating both types of strategies, yet providing the exposure to the market that the client needs,” he says.

Daugs also notes the potential benefits of active management for capital gains tax-loss harvesting, the process of recognizing losses in a taxable account. These can be offset against gains to minimize the tax owed.

“By keeping the passive management assets invested and utilizing the more active individual stock portfolios, you are able to pick and choose which stocks to sell to lock in gains and offset those with losses that may be in the active management portfolio,” he says.

[Read: Advisors: Is It Time to Adjust Your Investing Strategy?]

Minimizing Capital Gains Taxes

Capital gains concerns loom large in taxable accounts. It’s not uncommon for an advisor to bring on new clients who have held equities for years in taxable accounts. These holdings can have enormous capital gains, meaning a sale could result in a big tax bill.

When an advisor uses active management, it must be balanced with tax efficiency, says James Demmert, founder and managing partner of Main Street Research Wealth Management in Sausalito, California.

“Most clients have significant nontaxable assets, such as an (individual retirement account), as well as taxable accounts such as a trust,” he says. “As an active manager, we leverage the IRAs to do most of the selling if possible, thereby mitigating capital gains taxes.”

In addition to using individual stocks and bonds, Demmert’s firm uses a three-pronged approach called active risk management.

This approach, he says, “incorporates the flexibility of reducing overall equity exposure, staying in healthy sectors and the use of carefully placed stop-loss orders.”

Demmert adds, in a bull market, this process can remove poor-performing stocks or sectors. Such risk management, he says, is part of the firm’s fiduciary duty.

“If some of the sold stock is in an IRA and some in a taxable account, the taxes are not as pronounced. We can also use any losses to trim unrealized gains,” he says.

Ryan Cullen, founder and CEO of Cullen Investment Group in Cincinnati, says his firm’s strategy tilts toward long-term passive management. However, certain events warrant short-term active plays.

Cullen cites Chinese stocks, which began tumbling earlier this year, losing billions of dollars in market capitalization.

“While everyone was panicking, we used this as an opportunity to go overweight Chinese stocks and have already seen tremendous gains in them,” he says.

Mixing Styles for Flexibility

Using a mix of active and passive investments works for some clients.

“One of the biggest reasons is the flexibility it provides from a tax perspective. It’s particularly valuable in taxable accounts,” says Philip Weiss, founder of Apprise Wealth Management in Phoenix, Maryland.

Weiss cites a recent Vanguard study that showed tax-loss harvesting can boost annual portfolio returns.

“Some clients also desire more customized solutions. This would be another reason to hold some individual stocks,” Weiss says. “Research I’ve read in the past says that often a portfolio manager’s best ideas truly do outperform.”

However, he cautions against owning too many names, which can water down performance. “For example, your top 10 holdings might outperform overall, but a portfolio of 50 or 100 stocks might not,” he says.

There are pros and cons of individual stocks, actively managed funds and index funds, says Clark Kendall, president and CEO of Kendall Capital in Rockville, Maryland.

He says individual stocks have a role in tax planning beyond tax-loss harvesting, as account owners can donate shares to a charitable organization or hold them in a donor-advised fund. Appreciated securities can also be gifted to children or grandchildren who will likely be in a lower tax bracket.

The fact that active and index mutual funds distribute capital gains at the end of the year could be a downside to an investor who doesn’t want those gains.

“For most individuals, is it more favorable to use mutual funds in retirement accounts when the distributions of capital gains from the funds is not a taxable event? Only the distribution of funds from the account is the taxable event,” Kendall says.

[READ: Questions to Ask Advisors on Their Investing Strategy.]

ETFs for Active Management

Some advisors use exchange-traded funds to implement a more active approach.

During times of moderate fiscal and monetary stimulus, his firm invests in a diversified portfolio of domestic and international equity ETFs, says Ariel Acuna, founder and president at LTG Capital in Newton, Massachusetts.

“When a significant bear market hits like last year, where the government unleashes massive fiscal and monetary stimulus, we bet on the recovery by exiting our ETFs and investing in levered domestic ETFs,” he says.

When the stimulus is largely withdrawn, Acuna’s strategy is to exit the leveraged ETFs and return to regular ETFs. He says this method of active management has outperformed the S&P 500 and other major equity indexes over an 11-year time frame.

There can also be a behavioral component to an investor’s choice of active versus passive management, whether using funds or stocks.

Kendall says the biggest advantage in owning individual stocks is the opportunity to understand and appreciate the underlying company.

“For example, during equity market downturns, it is a great time to own good companies like (Procter & Gamble) because people keep on using toilet paper,” he says. “It’s a great time to own Colgate because people keep on brushing their teeth (and) great to own Verizon and Apple because my kids keep on texting me on their iPhone.”

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