This column is prepared by Doug Holthaus, vice president and relationship manager at PNC Wealth Management. He can be reached at 410-237-4590 or douglas.holthaus @ pnc.com.

To Index, or Not to Index
A popular recent question we have been hearing from clients is, “Should I use index funds or active managers for my investments?”

To review, passive investment management attempts to replicate, as closely as possible, the return on an index (for example, the S&P 500®) typically by purchasing the majority or all the securities in an index in the same weighting as they are held in the index. Meanwhile, active investment management does not attempt to replicate an index, but rather purchases securities in different weights than the index in an attempt to outperform an index or some other benchmark.

PNC’s view is that there is no objective way or need to officially declare active or passive investing the winner. Investors need only look at the marketplace to see that both active and indexed investment products have found a place in investment portfolios. We believe that an investor should purchase an investment product with a goal or purposes in mind, taking into account the different costs and benefits inherent in each. Some investors may be better served by active investments, some by passive investments, and some by a mixture of both.

Still, many people are asking if now is the time to increase exposure to active management. History has shown that the market tends to be more volatile when nominal GDP is low. With nominal GDP expected to be low for some time, increased volatility should, in theory, provide more opportunities active managers can take advantage of. Others argue that with valuation spreads as wide as they now are, the opportunities for active managers are larger. In fact, Empirical Research Partners has compiled data back to 1963, and this does seem to be the case in terms of the percentage of general equity funds outperforming the S&P 500.

Unfortunately, this indicator seems to be a relatively imprecise timing tool. It probably has better explanatory power than it does predictive power of what will happen in any given year. While we are sympathetic to these arguments that now is the time to increase exposure to active management, we’ll resist their siren song. We continue to hold the view—much like when an investor considers an asset allocation—that the investor’s primary focus should be on individual goals and risk tolerance.

Taking this into account, a useful metric might be to consider how much tracking error, if any, an investor can stomach. Tracking errors are typically discussed in terms of an annual percentage number—for example, a portfolio might have a tracking error relative to its benchmark of 2% per year. It is important to note this can apply to both upside and downside differences relative to the benchmark, so in the previous example, the portfolio’s potential is to outperform or underperform a benchmark by 2%.

We would argue that underperformance (negative tracking error) at times is in fact the necessary byproduct of a robust active investment management process. One cannot expect outperformance over longer time periods without periods of underperformance. For that reason, it all comes back to how much tracking error an investor can stomach, as determined by their individual goals and risk tolerance.

For more on this and any other topic, please feel free to give me a call. You can also visit us at pnc.com/wealthmanagement.
The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management.