There are a number of very practical advantages to asset-class investing:
Planning
As noted previously, available historical data allows us to form reliable estimates of the risk and correlation of most asset classes. An investment advisor can therefore estimate the risk of different combinations of asset categories and find the overall portfolio strategy that best suits the customer’s circumstances and risk tolerance. The advisor can then form a long-run investment plan, which can be implemented exactly by investing in those same asset classes via passively-managed funds.
In contrast, actively-managed portfolios seldom bear a reliable relation to any asset class. It is generally difficult to estimate future risk levels of actively-managed portfolios, or to know how an active portfolio will relate to various asset classes in the future because such portfolios may experience radical shifts in their strategy. Thus, it is nearly impossible to engage in or implement long-range planning if the tools are actively-managed portfolios.
Performance
Actively-managed funds and active managers consistently fail to out-perform unmanaged asset classes. From time to time a few active managers may appear to have the ability to “beat the market”. However, it is very difficult to determine whether their success is attributable to luck or skill, since the long-time series of data needed to do so is generally not available, and it is impossible to identify them in advance.
Cost
The expense ratios for actively-managed funds are significantly higher than those of passive funds. Active managers periodically reshuffle their portfolios in an effort to keep them stocked with only the most promising securities. The costs associated with generating and implementing these revisions make active management the most expensive investment approach. These expenses are passed along to the client.
Tax-Efficiency
Asset class funds are more tax-efficient than actively-managed funds. This is primarily due to lower portfolio turnover (less buying and selling) – asset class fund managers generally only make portfolio adjustments in response to changes in the underlying benchmark. As a result, asset classed portfolios generally have relatively higher after-tax returns.
A few fund companies – like DFA – have taken the goal of tax efficiency further. Since value funds tend to have higher dividend yields, and both value and small cap asset class funds incur higher turnover than S&P 500 or “total market” asset class funds, certain techniques can be employed to minimize taxable distributions to mutual fund investors. Special “tax-managed” mutual funds have been developed as a result.
Investments and insurance offered through the Trust Department of First National Bank & Trust Co. are not insured by the FDIC, are not deposits or other obligations of, and are not guaranteed by, any bank or any bank affiliate. Investments are subject to risks, including possible loss of principal amount invested.