There’s been a great debate in investing for decades: Should you go passive or active?
Passive investors love low-cost ETFs. Active investors believe in stock pickers. But when we audit portfolios, we almost always find the same thing: clients unknowingly have one foot in both camps. They think they own “active” funds — but in reality, many of those funds are just closet indexers.
Example
A client once told me proudly: “I only invest in low-cost passive ETF Funds.”
But when we audited his portfolio, he had over 40,000 positions. While his turnover ratio was under 6% and his expense ratio was below 0.10 percent, his portfolio had over 2,400 transactions a year. Those hidden transaction costs really impacted his portfolio’s performance.
The Great Debate: Passive vs. Active
- Passive (ETFs & Index Funds): Low cost, heavily diversified, efficient. Perfect for investors who want to simply ride the market.
- Active (Fund Managers & Stock Selection): Higher expense ratio’s, but with potential benefits if managers do real research and focus their energy.
But here’s the secret: you don’t have to pick a side.
With Separately Managed Accounts (SMAs):
- You pay a small fee for direct access to institutional managers’ research-driven portfolios.
- You own the individual stocks directly, not pooled in a fund.
- That means you don’t pay both a fund manager and your planner. Instead, your advisor is only paid for financial planning, tax coordination, and strategy.
This is ETF-like pricing with intentional investing.
Turning on the Light: Active Share
In 2009, professors Martijn Cremers and Antti Petajisto introduced Active Share, a measure of how different a fund’s holdings are from its benchmark.
- 0% Active Share = just the index.
- 100% = no overlap with the index.
- Closet indexers: 20–60% range.
Their research showed:
- Low Active Share funds underperform — because they are the index, just more expensive. It’s Just mathematics. Being a closet indexer with higher fee’s, means you are just going to perform as the index does and then fall further away because of your higher cost.
- High Active Share funds (75%+) have the potential to outperform — because they’re actually different.
Closet indexers lose by simple math: they charge more but deliver index-like performance.
Why Research-Driven Portfolios Work
High Active Share managers:
- Do deep due diligence (visiting companies, analyzing leadership, studying risks).
- Hold fewer positions (often 50 or less) with conviction.
- Take the same approach that Warren Buffett and Berkshire Hathaway are famous for: long-term ownership of carefully researched companies.
This isn’t day trading. It’s long-term institutional-level research packaged for individual investors.
Turnover Myth: Active Equals Trading Frenzy
Consider this:
- An Exchange Traded Fund Portfolio with 10,000 positions and a 6% turnover = 600 trades.
- A focus Separately Managed Account with focused investing and high Active Share with 100 stocks and 15% turnover = just 15 trades.
The point? High Active Share doesn’t mean high activity. It means focus and conviction with a long-term time horizon.
The Benefits of High Active Share + SMA Ownership
- Potential for outperformance.
- You feel more in control of where your strategy is leading you.
- Lower volatility, with focused ownership.
- Direct tax management (harvesting gains/losses can lower realized gains).
- Transparency, you see and own the stocks directly.
- Lower all-in costs compared to paying both a mutual fund and a planner.
In Summary
Passive funds are great for broad exposure at a low cost. But if you’re paying for active management, make sure you’re actually getting it.
With high Active Share portfolios in an SMA structure, you don’t have to choose. You can have both low cost and intentional, research-driven investing.
Are you ready for low-cost intentional investing? Let’s design your SMA portfolio.”
References
- Cremers, M., & Petajisto, A. (2009). How Active Is Your Fund Manager? A New Measure That Predicts Performance. Review of Financial Studies.
- Kitces, M. (2016). Using Active Share to Avoid High-Fee Closet Indexers.