July 2007

Active vs. Passive Investing

Indexing, a form of passive investing, has attracted a lot of attention lately, as evidenced by the explosion of literally hundreds of ETFs (exchange traded funds) now in the marketplace. These “funds” own, or simulate owning, all the securities contained in a specific index such as the Standard and Poor’s 500 Index or the Russell 3000 Index.

One of the traditional arguments for indexing has centered on the low fees charged by these funds which can be attributed to the fact that there is no investment manager actively making investment decisions. Rather, changes are made in these funds as individual securities are either added or deleted from the indexes themselves. Indexing is considered to be passive in nature expressly for this reason. But if an investment advisor covers his fees, he can be worth his weight in gold to a client. An investment advisor will meet with a client on an ongoing basis, analyze every aspect of the client’s specific financial situation, customize an investment portfolio that reflects the client’s unique goals and risk tolerance and continue to monitor and make changes as appropriate. Needless to say, this will never happen with an index fund.

Another argument for indexing is rooted in the Efficient Market Theory which holds that stock prices generally reflect all that is publicly known about a company. Thus, theoretically, an investor is better off buying a fund that tracks the entire market than one attempting to find undiscovered stock gems. While it has proven a challenge to outperform the indexes over time, there are strategies that have produced higher returns and with less risk than the indexes. This suggests that the market might not be entirely efficient.

An article by Vern Hayden entitled “The Death of Indexing” in the Journal of Financial Planning in June 2004 referenced John Bogle of Vanguard Funds, acknowledged to be the “father of indexing”. In it, Mr. Bogle himself admitted that over the long haul, investors in actively managed funds would have earned higher returns – and taken less risk – than those who put money into the company’s famed index funds.

Active management even makes more sense from a tax-advantage standpoint. Combining a reliable stock selection strategy with a disciplined portfolio process that maximizes expected after-tax returns has proven to consistently add value over an index on an after-tax basis. In fact, research shows that portfolios constructed using this methodology could have added one percent to two percent in after-tax returns above an index, over a ten year period with negligible, if any, incremental risk.

Active management has grown more favorable as investors increasingly look for value in today’s uncertain market environment. At RiverPoint, we have demonstrated to our clients that the powerful combination of successful active management and tax efficiency provides an overall return that beats passive management from both a performance and a client service standpoint.

Predicting the Weather?

Over the past few years, the general level of interest rates has risen from historical lows. In early 2003 the 10-year U. S. Treasury bond was yielding less than 3.5% and is now yielding just over 5%. While yields are still low on a relative basis, rising rates typically signal an impending economic slowdown. Conventional wisdom holds that higher rates mean trouble for both investors and the economy. Companies are forced to pay more interest on their debts, threatening profits. Without fat corporate profits to fund large scale capital spending, economic growth can slow. Consumers cannot afford the goods they could with “cheaper money”, further hampering economic growth. Implicitly, higher rates signal expectations of higher inflation which reduces the future purchasing power of today’s earnings – not to mention the present-value of the principal due at bond maturation. Finally, higher rates on “risk-free” U.S. Treasury bonds lessen the appeal of riskier assets such as equities and corporate bonds.

This time, however, “things might be different” as many economic wonks are wont to say. As stated earlier, interest rates are still low on a historical basis; ten year obligations have averaged a yield in the vicinity of 5.25% for nearly two centuries. In addition, given that interest rates have been falling since the early 1980’s, a rise in rates is probably more a question of “when” rather than “if”. Some even argue that in this age of financial globalization higher rates could be a sign of economic strength. In the past, foreign investors would buy only U.S. Treasuries (bond yields move inversely to prices so buying bonds raises the price and lowers the yield) which would lower rates. Nowadays, these investors are more willing to invest in riskier securities, which is a sign of their growing comfort with global financial markets and the stability therein. Finally, bond yields are still less than the earnings yield on the S&P 500 (roughly 5.9% based on trailing 12-months earnings). According to some market practitioners, this is a sign that stocks still have room to appreciate before bonds become a more attractive alternative.

At this point, it is difficult to say with any confidence what the immediate future holds for the United States economy. If history is any guide, attempting to predict the course of interest rates can also be an exercise in futility. That aside, it can be reasonably deduced that rates will “go up” - but by how much and for how long? The concern is that a rise in rates could portend a recession on the horizon. But there is also the possibility that rates could merely revert to the historical norm. Macroeconomic indicators are mixed, failing time and again to generate any kind of consensus within the investor community. At RiverPoint, we are working to position our client portfolios to perform well in any type of environment.

Market Summary	6/29/07	YTD Price Change
Dow Jones Industrial Average	13,408	7.6%
Nasdaq Composite	2,603	7.8%
Standard & Poor’s 500 Index	1,503	6.0%

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