Equity investors increasingly invest in funds with passive strategies.
Instead of using an active strategy of picking certain stocks, passive funds park money in assets with returns based on stock indexes reflecting the whole market, the good, the bad and everything in between.
But active strategies can outperform passive ones, not only in stock trades but also in real estate investments.
Morningstar reports that mutual funds and exchange-traded funds (ETFs) are managing $6.8 trillion of assets under passive, index-based strategies, up from $2.7 trillion in 2013.
About a third of U.S. assets are managed under passive strategies, and the proportion is rising rapidly as more money moves to passive funds from actively managed funds.
Many active money managers have responded to the passive index-based trend by rolling out equity funds with so-called “focused strategies,” or funds with holdings in 50 or fewer stocks.
More than half of 91 institutional investors surveyed from September to November by Greenwich Associates and Fred Alger Management Inc. said they had increased their portfolio allocations to focused-strategy funds in the previous 18 months.
Part of the appeal of focused-strategy stock funds is the expectation that they include the stocks that the fund managers like best.
Returns on funds holding 50 or fewer stocks also are unlikely to correlate with returns on funds with so many stocks that they mimic a stock index.
Jim Tambone, chief distribution officer of Fred Alger Management, said mathematical probability explains why focused strategies offer bigger potential returns than passive strategies.
The probability of outperforming the market is far greater with 10 stocks than with 1,000 “because once you’re at 1,000, you’re essentially the market,” Tambone said.
Active-strategy returns also can exceed passive-strategy returns in real estate investments.
Consider, for example, the acquisition and renovation of a rental apartment building. Whether a passive or an active investment strategy is best for such a project depends on which strategy best fits the investor.
A passive investor in an apartment project is a limited partner with no control over the business plan, so trust in the project’s sponsor is critical.
A passive investor can further reduce risk by insisting on a preferred return, an agreed-upon return that is paid before the sponsor collects any compensation.
An active property investor, by contrast, would exercise direct control over the plan for acquisition and renovation, over decisions about the type of tenants accepted and the rent charged, and ultimately, when or whether to refinance a property or sell it.
Along with taking more control, an active investor in a rental property project takes bigger risks and makes a bigger commitment of time than a passive investor.
Among the common mistakes that expose active investors to large losses are underestimating renovation costs and overestimating rental income.
But obviously, the potential rewards are also greater for an active investor who owns 100 percent of a real estate project instead of sharing it with partners.