Hybrid Portfolio Management – Combining the Best

Market Buzz – Hybrid Portfolio Management – Combining the Best of Active and Passive Strategies

The first decision an individual or institution has to make, if they desire to invest in securities (stocks and bonds), is whether or not they will utilize an active or passive portfolio management strategy. Whether they know it or not, this is a decision that every investor makes. Portfolio management is often a segment of the investment process that many individuals miss, but although overlooked, it can often mean the difference between success and failure in the long road of investing. Since everyone has to make this decision, consciously or unconsciously, it’s important to know exactly what your options are.

The majority of investors, private and professional alike, will opt to follow an active portfolio management strategy. This is when you will make decisions on buying and selling individual stocks and bonds. You will either do this independent, or you will pay a professional advisor or portfolio manager to do it for you. The alternative to active management is a passive portfolio management strategy. This is when you put your money into index mutual funds (a specific type of mutual fund) or market ETFs, which are intended to replicate the return of the overall market. Neither you nor any advisor or portfolio manager will make decisions on individual stocks or bonds in your portfolio. Your portfolio would be indexed, to include the same stocks in the same proportions as a market index, such as the TSX (Toronto Stock Exchange) or the S&P500.

Both the active and the passive strategies have their advantages and their disadvantages. The advantage of the passive strategy is that it is a lot less work and the fees are much lower. You don’t have to pay analysts and portfolio managers to research stocks and make decisions. Because of this, your management expense fees will be very low, usually in the range of about 0.2%. You also don’t have to spend a lot of your time following your portfolio. Just check in every once in a while and make sure that your portfolio is roughly keeping up to the overall market. If it is not, there is a problem and you will have switch into different index funds and ETFs, but typically passive investment is fairly work free. Long term, the market has delivered an average return of about 7% per year. Using the passive strategy, you might reasonably expect an average return of about 6% from the stock portion of your portfolio (remember a diversified portfolio would have bonds as well). The disadvantage of a passive strategy is you are not going to generate an above-market return. If the market does well, you will do well. If the market does not do well, neither will you. There is no potential to generate higher returns than the market, but it is a good option for investors who would be satisfied with this return and don’t want the headache of constantly monitoring their portfolios.

The active strategy seeks to beat the market by purchasing individual stocks or bonds that are expected to generate superior risk-adjusted returns. The advantage over the passive strategy is that you can theoretically generate an unlimited return. The problem is that the active strategy is much more costly and is usually pursued with limited success. As we said, the vast majority of the investment community utilizes active portfolio management. Even most investors that just purchase mutual funds or contribute to their pension are also utilizing an active strategy. They are simply paying fees to professional managers to make the investment decisions for them. Average management fees for a mutual fund will usually run between 1.5% and 2.5% (a far cry from 0.2% for index funds). This is the amount of your total investment that will be charged for active management every year, regardless of whether or not the active management was successful. If a fund is charging 2% in fees and the market returns 6% that year, the fund must generate a return of at least 8% for the active strategy to just breakeven. Unfortunately, the vast majority of actively managed funds (estimates as high as 80% per year) actually underperform the market. What’s more, most funds that outperform the market in any given year do not do so on a consistent long-term basis. So, essentially investors are paying high fees for superior performance and in all but a few cases, are receiving inferior return. Investors that utilize financial advisors, or who go it on their own, typically do not fair any better and often do quite a bit worse.

So when we add up the facts, it actually appears as if passive management comes out ahead. It is less work, it is cheaper, and statistically, it generates better returns over time. So shouldn’t we all just utilize the passive approach? For the average investor the answer is likely to be a resounding ‘yes.’ However, in some specific cases (albeit a minority) there are individual investors or professional money managers that can successfully generate superior returns to the market over a long-term horizon. If an investor is one of these individuals, or has access to one of these advisors, then utilizing an active, or at least a hybrid portfolio management strategy, may provide excellent benefits.

A hybrid portfolio management strategy is when you allocate a percentage of your portfolio to passive investments and a percentage to active investments. If an investor has a portfolio worth $200,000, they may want to do a 75%/25% split between passive and active investments, or a 50%/50% split, or if they want to be very aggressive, a 25%/75% split. The options are nearly limitless, but the specific allocation depends completely on the individual. The advantages of the hybrid strategy are that it combines the benefits of the two individual approaches while also mitigating some of their respective drawbacks. For example, utilizing the hybrid approach gives you at least some potential to outperform the market, but if your active strategy is unsuccessful, you still have a portion of your portfolio earning the market return. Fees and time invested will also be lower than with the active strategy.

The key to being successful with either the hybrid or active strategy is making good investment decisions. As discussed, this means the investor either needs their own investment knowledge or must pay for the investment knowledge of a professional. Ideally, it is a combination of both. Either way, the knowledge must be sufficient to outperform the market – not an easy task, but certainly not impossible. Knowing whether or not you have the right advisor is also not an easy task. If you have a long standing relationship with your advisor and they have provided you with consistently good advice, then that is a start. While we would never recommend that you rely on past performance as an indicator of future performance, a long standing track record of beating the market (through various market cycles) and successfully mitigating risk is a strong foundation. If you are new to an advisor, a good strategy would be to start with a small allocation to active management and just see how they perform. As they build your trust, you can incrementally increase your allocation to active management over time.

We cannot provide specific portfolio management advice because this is impossible to do responsibly without direct and detailed knowledge of the individual. However, to provide a little more color on what specific hybrid portfolios might look like, we have provide two example below. These examples are of two fictional individuals that exist at nearly opposite ends of the risk spectrum. While the information provided is very general, most individuals will have a risk tolerance somewhere in between the two examples provided.

Hybrid Portfolio Case Study – Mr. Young
Mr. Young is a 28 year old male with a full time job and no dependents. He currently has minimal debt obligations and has just received an inheritance of $80,000. Although Mr. Young currently has no investments, he has started to think about his future (including retirement) and has decided to use his inheritance to build an investment portfolio. Being young and without financial obligations, Mr. Young recognizes that he is in a position to take on an above-average level of risk. Although he is interested in the high-returns that he could potentially receive from the stock market, he is also worried that in an attempt to generate these returns, he could end up losing a large portion of his inheritance. To help to mitigate some of these loses, Mr. Young has decided to utilize a hybrid portfolio management strategy. Mr. Young will allocate $40,000 (or 50% of his portfolio) to the basket of index funds and ETFs that are intended to generate a return roughly equal to the market return. He has decided that to hold these investments for at least 10 to 15 years and will only monitor them periodically. With the remaining $40,000 (or 50% of his portfolio), Mr. Young will buy and sell individual stocks. Because he does not have extensive financial expertise himself, Mr. Young has decided to utilize the financial advisory services of KeyStone Financial Publishing Corp. This hybrid portfolio is allocated 50% to active management and 50% to passive management.

Hybrid Portfolio Case Study – Mrs. Pension
Mrs. Pension is a 75 year old window who lives off of her government pension and income generated from her investment account. While Mrs. Pension has no dependents, she must tightly control her expenses as well as tightly manage risk in her portfolio. Mrs. Pension uses a financial advisor provided by her bank to help her manage her investments. She believes the advice that she has received is essentially sound, but is hesitant to completely rely on the advisor. Mrs. Pension’s retirement savings includes an investment portfolio of $200,000, which is primarily invested in indexed bond funds that deal in government and AAA debt. Recently, Mrs. Pension has decided that she wants to take a small portion of her portfolio to invest in higher-risk stocks. The purpose of this activity is to provide some extra funds to her grandchildren, once they start college. After extensive consultation with her financial advisor, Mrs. Pension has concluded that she could very safely remove $10,000 from her investment portfolio for the purpose of actively investing in higher-risk stocks. She knows that even if she lost the money, she would still have sufficient income from the rest of her portfolio to meet living expenses. Based on the success story of a close friend, Mrs. Pension has decided to utilize the financial advisory service of KeyStone Financial Publishing Corp to invest the active component of her portfolio. This hybrid portfolio is allocated 5% to active management and 95% to passive management.

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