by Michael Tarsala
We believe in active investing at Covestor.
So it may sound surprising to hear anyone from our company say that index funds — so-called passive strategies — can be a good way to invest.
They can. But they are not always the right choice, says Ralph Mennicken, Covestor’s chief investment officer, in an interview with Fox Business, in which he pointed out the pros and cons of the investment strategy.
The pros of index funds are:
- They usually have a risk-return profile similar to the index being tracked.
- As a result of buying an index, you get diversification.
- Expenses are usually lower than actively managed funds, and they’re tax efficient
The cons of index funds are:
- Some do not match the performance of the underlying benchmark all that well
- There still can be meaningful costs due to fees and rebalancing
- They lack flexibility; it can be hard to get defensive when markets are tanking
That last “con” can be especially important. Active managers often take profits along the way — they don’t just buy and hold.
More importantly, they have the flexibility to move to cash or to less sensitive sectors when market volatility begins to rise and prices start to fall.
One important way to gauge the volatility of an active manager’s strategy is to look at their max drawdown, especially in past downturns. A max drawdown is simply the largest percentage decline in an investment model from the peak in any given timeframe. At Covestor, we compare the max drawdowns of each investment model relative to the S&P 500.
Good managers beat the market, of course. But in my mind, the best do so by losing less in the downturns — and having a lot lower max drawdowns than the overall market as a result.
Talk to us if you want to find out more about active investing, or any of our investment managers.
