May 28, 2013

It’s Not Just Active and Passive, but Behavioral Finance That Best Meets Clients’ Needs

For decades, finance professionals have argued over the merits and drawbacks of active versus passive investment management, but in today’s world, that debate makes little sense, if at all, according to Ted Lundgren, managing principal of HG Capital Advisors and a member of the board of the National Association of Active Investment Managers (NAAIM).

Yes, Lundgren is a proponent of active management, but only as one part of a comprehensive investment strategy that also includes passive management, because, he says, managers and advisors will only be able to deliver the best to their clients when they properly mix both active and passive strategies.

While active management strategies and the value they can bring enhance advisors’ ability to add alpha, help respond to changing market conditions and overcome losses, they’re actually far more effective when they’re combined with passive strategies, Lundgren argues. That’s because those strategies can add a level of diversification across asset classes and timeframes.

“Our main job is to learn about the client and do what’s best for him, so diversifying across asset classes, methodology and investment styles is extremely important,” he says.

But no investment style, active or passive, can work without an advisor getting to know how their clients feel, think and behave. To that end, any advisor’s approach must be anchored firmly in the principles of behavioral finance, Lundgren says, and they must get to know their clients’ behavioral biases as well as their own in order to then come up with the “money management techniques that help mitigate these.” The trick is to be prepared for any market eventuality that can impact investor behavior and confidence, he says, and the best way to ensure this is to mix methodologies and investment management styles. 

Buy and Hold, and Active Management

“As an advisor, you don’t want to react for a particular market environment and say ‘We will do something,’ you already want to be prepared for it,” says Lundgren.

“You have to make sure that there’s some part of a client’s portfolio where a buy-and-hold strategy will work, and another portion that’s prepared to go cash in an extreme environment like what we saw in 2008. There are rules and discipline around that that are really important, so to the extent that we can diversify across asset classes, methodology and investment styles, we have a better chance of enabling clients to meet their investment objectives and stay invested in the market at all times.”

Despite all that financial market participants have been through, many advisors today are still arguing over active and passive management styles, and tending to veer toward either one or the other. But Lundgren thinks it’s time to set that argument aside and open up the discussion to more comprehensive, holistic financial planning solutions that incorporate elements of both approaches.

His paper, “Three Fundamentals – Using Active Management, Behavioral Finance and Planning to Reach Client Objectives,” was released April 29 at the 35th NAAIM Uncommon Knowledge conference in Denver in early May and is the first in a series on portfolio management techniques that Lundgren hopes will initiate healthy dialogue among advisors on both sides of the active/passive debate. 

Lundgren also hopes to shed more light on active management, a style he believes can be both overwhelming and difficult to understand for many advisors.

“We want people to know that ours is an organization that is there to help them understand how active management works and how they can integrate it into their practices without hurting their clients,” he says. “We want to broaden the discussion by first getting advisors to understand on a basic level how active management works and from there open up the conversation. Today, it’s clear that we are not going to get any traction by just digging in our heels and if we want lifelong clients, then it’s clear that neither active management nor passive management alone are enough, and we have to meet somewhere in the middle. We would like others to step up and join this conversation.”

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