Investing's Active-Passive Tug of War

Of course, passive management adherents don't believe in keeping a sharp eye on the market horizon for significant shifts because they wouldn't do anything about these signals anyway. But for those who prefer to act, it's a good idea to keep an eye on money flows in and out of specific stocks. When money's flowing out of a stock, there are more sellers than buyers, and many times that doesn't bode well for its price. When there are more buyers than sellers, especially when the price increase is on large volume, this could be a sign that big institutional investors are accumulating shares of the company and that demand will likely lead the stock higher.

During some periods, money flows can indicate changes in parts of the market that are positive compared with the overall market, or vice versa. For example, in late July, the Nasdaq was attempting to reclaim a leadership role as it had higher inflows while the S&P suffered after low inflows. The passive management credo includes a belief in the buy-and-hold philosophy of investing. They believe that once they set up a sound asset allocation , all they need to do is maintain that allocation through periodic rebalancing and they'll be fine, because market upturns will more than compensate for downturns over time.

The buy-and-hold crowd typically adopts formulaic asset allocations that have been around for generations but no longer tend to make sense. This worked fine as long as certain assumptions held true. For example, for someone with an average risk tolerance approaching retirement, the classic allocation formula calls for a hefty allocation to bonds, around 40 to 60 percent. From the early 1980s until recently, this bond allocation worked out great as interest rates peaked and began to decline. Now, these rates are so low that there's almost nowhere for them to go but up with inflation (also quite low historically).

But when interest rates begin to rise, bonds could be a significant drag on your portfolio. If you're 55 years old and accept the bond allocation at face value and load up on 30-year bonds, your portfolio could be hurting when inflation and interest rates rise.

So instead of using a set-it-and-forget-it asset allocation, such investors are better off varying their allocations over time to reflect variable market conditions and changing risk.

Some people seek to justify the bond allocation by saying that the best use of bonds is not to gain returns, but to reduce risk and dampen portfolio volatility.

This dynamic was visible in 2008 in the Lehman Brothers Aggregate Bond Index (rebranded as Barclays Aggregate Bond Fund in November 2008), used to track bond market trends.

On September 12, 2008, a key exchange-traded fund (ETF) tracking this index, the iShares Aggregate Bond Fund (AGG), was trading at about $101 per share. A few weeks later, on October 10, 2008, it had dropped to around $88 per share. Thus, risk was hardly reduced.

Anyone loading up on bonds now to counteract market volatility might be disappointed when interest rates begin to rise, triggering bond declines. Bonds have a time and a place in most portfolios, but to just blindly allocate a large position without regard to the current economic outlook doesn't make sense – especially for those in retirement who, above all, want to avoid going back to work.

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