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Active or Passive Asset Management? Wrong Question, Investors

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Investors should stop spending time on whether active or passive strategies are best, and focus on whether or not their assets are arranged so as to achieve highly specific goals.

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I attended a celebration in honor of the 20th anniversary for the creation of the first ETF ever, State Street's SPDR S&P 500 ETF (NYSEARCA:SPY) in Manhattan on Tuesday. It was a swish affair, as perhaps it should be, given the revolution this product launched.

During the hours leading up to the reception, I kept working through the question that has burned brightly since SPY was launched: Which is superior, active, or passive asset management?

The funny thing is, I arrived at conclusion this time, but not wanting to be a spoiler at the ETF party, I resisted a skyward shouting "Hallelujah!"

But here it is: Active management is superior to passive, hands down.

Here's the reason why: Passive asset management is only theoretically possible. In reality, we are all active managers. That's because nobody but nobody puts all their assets in SPY or the Russell 2000 (INDEXRUSSELL:RUT) for a lifetime. Investors diversify into fixed income, or emerging markets or cash, and the thinking that leads to these adjustments is in fact active asset management.

The only remaining question is whether your asset allocation is done by a professional advisor or something you do on your own. Keep in mind that even among the best and the brightest, stitching together a winning track record for a prolong period of time is difficult work.

To see this, check out the SPIVA analysis, where SPIVA stands for S&P Dow Jones Indices versus Active. It's the information giant's best attempt to get an apples-to-apples comparison of how active managers stack up against indexes.

Specifically, the analysis suggests for a mutual fund whose performance was in the top quartile of all domestic mutual funds in September of 2010, there's a 90% chance that by September of 2012 the fund's performance was somewhere among the bottom three quartiles. Similarly, if you picked a mutual fund whose performance was in the top quartile of all domestic mutual funds in September of 2008, there's 99.82% chance that the fund's performance would be somewhere among the bottom three quartiles by September of 2012.

There are several reasons that prevent active managers from consistently staying on top. They include the cost of information, so called "closet indexing," and restrictions imposed by the fund's charter.

So where does this leave us? Unless you put your assets in a broad market index for life, or manage them yourself (presumably at no cost, unless you tally up the value of your time), you are constrained to market or near market returns. My advice to investors is stop spending time on whether active or passive strategies are best, and focus on arranging your assets in a way so as to achieve highly specific goals.

Just so you know that I eat my own cooking, to meet the mandate of the GMG Defensive Beta Fund which I co-manage, which is long-term capital appreciation with less volatility than broader equity markets, here's are some of "passively managed" indexes we've put to work.
Follow Oliver Pursche on Twitter: @opursche.
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