Why Some Investors are Paying Extra to Protect Themselves Against this Volatile Market

March 2nd, 2018 by Tanner Wrisley

The markets are starting to show signs of uncertainty with large daily swings in the stock and bond markets. This volatility is being brought on by fears of inflation and rising interest rates. The United States economy is growing; fourth quarter GPD growth was confirmed on Wednesday by the US Department of Commerce at 2.5% and unemployment as low as 4.1% compared to a historical average of about 6%. These positive economic indicators have the Federal Reserve worried about inflation. As I outlined in my previous article, the Fed will raise interest rates as a way of preemptively striking against inflation. An action to raise rates typically lowers bond prices and constricts the stock market. This helps to slow inflation, but may also cause a downturn in both of these markets. Given the reality of the current situation, investor’s confidence is wavering, causing these large day-to-day swings.

Now that you have a background on what our economy is doing, let’s dive into a question that all investors face: Is active or passive investment management more effective. Both have strengths and weaknesses and certain economic atmospheres can bring one management style more popularity over the other.

A passive management style attempts to take market timing and emotion out of the equation with a simplistic buy, hold, and rebalance mentality. These portfolios usually follow an index and are rebalanced on a fixed schedule. For example, a passive investor might have their principle invested and have their portfolio rebalanced two times a year. If a certain security performed really well over the first 6 months and is now taking up a larger allocation of the overall portfolio, that security will be sold and the proceeds from the sale will be used to purchase securities that didn’t perform as well. The point here is that you are forced into selling high and buying low. This type of scheduled rebalancing and passive style makes sure that trades are emotionless and that the investor will not get burned by trying to “time the market”. Rebalancing like this also minimizes trading costs and management fees with trades only being placed a few times a year. There are less transaction fees to pay and less work for the portfolio manager to charge for.

Active management styles trade and rebalance based on the money manager’s perception of market conditions. For example, instead of rebalancing semiannually, one’s portfolio is adjusted based on the market and what the portfolio manager believes will be the best performing assets in the near future. If the portfolio manager believes the market is headed for a downturn, he or she can pull out of stocks and move into cash in order to protect the investors from some losses and have extra buying power to purchase stock at a lower price. This type of management attempts to protect investors from taking the brunt of a market downswing that would be taken on through passive management. Active management may also include strategies to beat a market index over a given time period through tactical trading or investment selection. This style lends itself to higher costs because it calls for more trades and closer scrutiny and hands-on involvement from the portfolio manager. One basically pays for the chance at higher than market returns in a bull market, or less of a loss in a bear market.

With passive investing you know what you are going to get: market performance. In a market that goes up and never goes down, passive is the clear winner, just put the money in and wait for it to grow. However, in a market with ups and downs, there are opportunities for better performance and greater downside protection with a well implemented active management strategy. With the way the market is currently behaving, more investors are turning to an active management strategy as a way of protecting themselves from experiencing some of this market volatility. Typically, if you are willing to take risk and have a long time horizon for investing, a passive strategy will be appropriate. If you are approaching retirement, or you feel uneasy about too much of a negative fluctuation in your money, it may be a good time to implement an active strategy to your investments.