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Active vs. Passive Investment Management:

Whenever there’s a discussion about active or passive investing, it can pretty quickly turn into a debate because investors and wealth managers tend to strongly favor one strategy over the other.

Jeff Powell, CIO, Managing Partner & Founder of Polaris Wealth & Jeremy Witbeck, Partner at Polaris Wealth, & Matthew Erickson, Senior Portfolio Manager, provide their thoughts on their roles and responsibilities as investment managers and their approach of portfolio management for Polaris Wealth Clients.

All right, welcome to the Polaris podcast. This is Jeff Powell, managing partner of Polaris Wealth Advisory Group. Today with me, I have Jeremy Witbeck, partner of Polaris wealth advisory group, as well as Matt Erickson, our Senior Portfolio Manager. Today, we are going to flip the switch. Normally, I’m not doing the intro, and normally, I’m not doing a lot of the questions that are being asked, but we’re gonna flip the switch a little bit. As we talk about active versus passive management, I really wanted to get some thought leadership, with Jeremy being a CFA, obviously, with Matt Erickson having the decades of managed portfolio management experience. Obviously, I come with a few years of experience myself, but I thought it would be kind of fun to flip the switch, and actually be the person asking the questions today, rather than being the one answering the majority of them. So I’m going to actually just hop into the subject matter of with active management and passive management, you know, obviously, has been a subject out there and the news for decades now. But perhaps germy, if you would, for me, when we talk about investment management, can you maybe describe the four main ways that investment management firms manage money for us?

Yeah, definitely. So when we look at asset management, there are really two extremes. And that is on the, the most passive side you’re buying hold type strategy. And then on the other extreme, your most active is market timing. And then you have a couple others in between. The one that most people are probably pretty familiar with, given that the majority of money’s managed this way, is what’s called strategic allocations, which is based on modern portfolio theory. Here, for those people that aren’t as familiar with that Harry Markowitz did a lot of work in the 50s, and found that there were benefits on holding different assets together to gain things like diversification, benefits, and really laid a framework that is still pretty well follow today. So you have strategic and then you also have tactical management and tactical is where you start to get much more active and making meaningful shifts within the portfolio. So tactical is where you will incorporate forward research and forward analytics and make portfolio decisions within the construction of the assets being managed to try to meaningfully either lean into areas of opportunity and strength and lean out of areas or completely remove yourself from areas of weakness,

and Polaris wealth advisory group, where do we fit into the mix of things?

Yeah, we’re strong believers that the way that we can bring the greatest value is by being tactical in what we do, um, that that is where we can fully incorporate the research and really bring the value that clients are looking for us in terms of managing their money.

And so with that being said, I mean, you went through four ways, were one of those four ways, but it sounds like modern portfolio theory is how the great majority of firms that a listener may actually run into, can you kind of go into a little bit more detail about you said, the risk framework, talk to me about the three main things to the framework of how a modern portfolio theory, personal work, and then obviously, we’ll get into a little bit more of how we manage money in a minute.

Yes, so a modern portfolio theory, it really looks at a lot of historical data points to figure out or calculate, I should say, rather, the allocations that are going to be used within a portfolio. And so the reason why you’ll often hear this described as kind of driving looking through the rearview mirror is because it’s looking at historical data. So typically, when you build a modern portfolio theory model, you’re incorporating things like correlation. So correlation is looking at how assets zig and zag together, you’re pulling in the historical return. And then you’re also pulling in the historical standard deviation, R, which is a fancy word for saying the historical risk of an asset and then using some pretty complex math that comes up with an allocation on how much you want to have in each of your individual asset classes. So the big challenge with that, and I would argue the biggest problem with that, though, is that we’ve learned that historical results are a terrible indicator of future results. And so when you’re building a portfolio based on historical data, it really is blindly going into the future. And that’s where we deviate greatly from the pack in the way that we manage money and being tactical that we’re strong believers and have a lot of conviction in using that for research and the portfolio decisions that we’re making, which is why we are a troop here tactical investment management firm. Yeah, I

couldn’t agree with you more. I mean, I think that the one of the examples that I always like to use About how we were getting out of energy, for example, back in 2014. It wasn’t for forecast to think that oil prices but actually had negative numbers. But it was looking at really the weakness within a particular sector of the market. And it took years for the average modern portfolio theory person to get out of those particular areas. Matt, shifting over to you for a minute. I mean, obviously, part of what Jeremy just was talking about is that modern portfolio theory, investors are using a lot of passive investment management to create asset allocation using ETFs using mutual funds, but maybe you could just give us a one minute two minute history of passive management and why it’s actually kind of come into existence and why it’s so prevalent to them.

Okay. So, yeah, I would say we’ve got a pretty long history here, of passive managers outperforming active. But that really started back in in the mid 70s, I believe it was 1974 when jack Bogle launched the first index based mutual funds, and that was off of the s&p 500, if I’m not mistaken, was 1993, when the very first ETF was launched exchange traded funds, right. So basically the same thing as the index mutual fund, except it trades intraday, whereas the mutual funds price at the end of the day, but we’ve really seen a tremendous amount of growth in that passive space. So to kind of put that in context, if you just go over the past 10 years, there’s roughly between index based mutual funds and index based domestic equity ETFs, there’s essentially been a money flow, so fund flow of $1.8 trillion into those index based equity products. And surprised probably not surprising, I guess, you’ve seen about 1.8 billion flow out of active managers. So you really have a few things going on here. Jeff, there’s the proliferation of the ETF marketplace as a whole, right? I mean, Originally, it was just five, the s&p 500, then a mid cap 400. And start breaking the sector’s and you know, 1020 years ago, the average investor didn’t use those things. Now everybody’s using them. Right. So what that’s done is, is meet itself to, I think, quite a few inefficiencies in the market, which I think actually put us in in a very, very good place. So to put that in context, you’ve got over the past 10 years, you’ve gone from 25% of us equity ownership was was owned by indices or index based products, if you will. Now that’s closer to 50%. So what that’s done is drive up value in the largest stocks to the point where now the five largest stocks and career produce the Fab Five, which we can get into more if we want to a little bit later. But you know, make up as much as 25% of, of the index itself of the s&p 500. But what happens when you see all this money going to indexing? One, it’s a self fulfilling prophecy, right? We’ve got indices that to a point, have outperformed. If you were to look at the speed of a report, for example, which is the s&p, s&p indices versus active report that comes out by annually, it measures essentially what percentage of active managers have outperformed passive indices. And over the past 10 years or so, it’s been about roughly and depends on the category, but roughly 90% of active managers have outperformed. So you can kind of understand why the industry is driven that way, they’ve been looking for lower fees, you know, they they’ve at the same time, they’ve thrown in the towel, on generating any modicum about performance. At which point, I think you got to ask yourself, how is it that these active managers are trying to outperform What is it they’re doing wrong? And what do we or should we do differently to give ourselves a greater probability to outperform? And I think tactically the first kind of run in that?

Yeah, so I mean, I couldn’t agree with you more. I mean, it’s it’s been a very interesting thing to see the numbers and how much they’ve climbed. I mean, it’s, it almost seems like people are giving up with regard to trying to outperform a like benchmark. And obviously, with indexing shares, having such low cost, trying to control costs that are involved with that. When we look at tactical investment management, obviously, you know, we’re not the type that’s gonna sit around and sit back and be okay underperforming an index. And obviously, we we take great pride in bringing value to the table. Perhaps Matt, you can kind of tell me a little bit more. You know, again, there’s three main points that we kind of talked about worth where we bring value to the table, one being tactical, the second, the concentration that we’ll take with any portfolio, and the last thing, being sector agnostic, kind of take us into it. Tactical investment management, you know, where you think that we’re bringing value to the table by being tactical.

Okay. So yeah, there’s three things, we should probably touch base on there, and you hit them perfectly there. So one is tactical. That is, in its simplest sense, the way I look at that is aligning underlying portfolio holdings with prevailing market conditions. Right? It’s really just as simple as that. I mean, there are times when the market is going to favor higher beta versus lower beta, which is just a basic way of saying the markets favoring higher risk securities, and then at different times, favoring lower risk. There’s also different factors that can come into play, there’s no one factor that works all the time. So tracking, whether it’s a quality factor, momentum factor, volatility factor, whatever it might be, and looking to see what essentially what is in favor, we can adapt our underlying holdings to those market conditions. And when you do so, you can mitigate Most importantly, I think the downside risk when markets pull back, the other way you can do that, obviously, is is by raising cash, which is another thing we’ve done here in some of the portfolios. So the next step, I’d say, is investing in order to outperform I think you got to have the three things, right. So tactical invest with the relative degree of concentration receptor nastic. So I covered tactical,

yes, with breaking it down, because I think it’ll be easier for our viewers. Okay. Listen to that. And, you know, one of the things you were talking about is, again, you know, with with shifting from higher risk to lower risk. You know, I think the other things to really kind of hit on that I think is very thematic, from our standpoint, you know, is some of of how we have raised cash and certain strategies, for example, within our more balanced strategy that are rising dividend growth and income strategy, for example, which is historically a 6040. strategy, we had ourselves down to 30% equity, and our growth and rising dividend growth strategy in our global growth and our socially responsible strategies, we were down to anywhere from 45 to 48%, stock and the rest was residual cash, because those strategies don’t go into bonds, germy, that was going to start getting into the other areas. But you know, what I’d like to do is maybe hear from you on really kind of the value that’s brought to the table by being a little bit more concentrated in our portfolios, can you kind of hit on the value that’s being brought to the table there?

Yeah, so in diversification is one of those things where it really got hit pretty hard when the concept was understood. And unfortunately, I think the industry suffered a little bit of that too much of a good thing, where diversification is important, never would recommend someone have all their portfolio in just a handful of positions. However, there’s a limit as to where you really start to get a meaningful benefit from diversification. And it actually, at some point, it really starts to water down the portfolio, and it ensures that you’re going to capture mediocrity within the portfolio, when you get too far. What the research shows is actually the ideal number of holdings within a portfolio is in that 20 to 30 range. And the reason for that is you still get the benefits of diversification, meaning that if you have one stock, that just really plummets and falls significantly short of expectations, it’s not going to sour the entire portfolio. By the same token, you’re able to benefit from your research, when you limit yourself to 20 to 30 holdings and you have an A good earnings report, right, that company has enough weight within the portfolio that it can actually elevate the returns. Now contrast that to what’s typically done today, where you have mutual funds that not only have hundreds, but in some cases, thousands of holdings. If one of those thousand holdings has a good earnings report doesn’t mean anything. In fact, it doesn’t really do anything within the portfolio, it’s just too small and too insignificant. And so diversification is important, but unfortunately, I find that it’s often abused and and completely misunderstood as to how it should be used appropriately.

Well, it’s really good point. I mean, what I think that we’ve certainly seen through a lot of our competitors that are investing in individual securities, rather than using mutual funds and ETFs is that they’re almost closet indexers. Because once you have gotten out to 4050, you know hundred stocks, as you’re saying a big movement and one of them isn’t going to change anything within our focus strategies. The focused income strategy or going in with 5% positions, 20 stocks, the concentrated, which again would be really only used as a supplement to diversify portfolio is going in with 10 positions. And then even our most diversified strategies were in the very low 30 is going in with 3% positions per so that when they are in that situation that we’re actually able to add some value being brought to the table. Matt, you were you were earlier kind of hitting on again, the three areas. So we’ve already kind of had a little bit on tactical. So tactical, obviously, meaning that we’re shifting from high risk to low risk. We’re moving from cash, from stocks into cash, or in baby stocks and into bonds, depending on strategy. We’ve already talked about that we believe in going in with a little bit more conviction, and believing in the research and really some of the theology that we’ve seen going on within this market. But really, in your article, you hit on a third thing, which is second being sector agnostic. So maybe kind of take our listeners through a little bit more of why being sector agnostic matters.

Okay, so the three things we’re talking about here anyway, the Tascam invest with relative degree of concentration sector agnostic, like I said, that’s, that’s to me, what gives an active manager the the chance to outperform? And I think this goes back to the whole and again, to put it in context, if you’ve got 90% of active managers failing outperform What is it they’re doing wrong? Well, one of the biggest things they do and just to reiterate what you said a few minutes ago, is they’re really closet indexing, they’ll look at a respective sector for their benchmarks. So for example, one of the strategies I run is focused value in the benchmark for that is the Russell 1000 value index. Well, historically, roughly 20% of the Russell 1000 value index is financials. And so the average active manager in that category is going to look to if if they’re overweight financials, they’re going to be let’s say, 22%. financials, if they’re underweight, they’re going to be, let’s say, 18%. But at the end of the day, they’re really not adding any discernible value, particularly if you consider how many stocks they’re holding, like, like Jeremy is just covering a minute ago. So we personally believe that look, if you’re an active manager, and if you want to give yourself the chance to outperform, you don’t just have to have conviction in the securities you’re holding. But in where you want to have exposure to the markets from a sector perspective, historically, during periods where I haven’t liked financials at all, regardless of the fact they’re 20% of the benchmark. I don’t I haven’t owned them. Right now, the same is the same thing about energy. You know, and and those some of those sectors that you have a higher conviction, you know, longer term like technology or consumer discretionary. You know, I think those warrant at times certainly a heavier weighting than the benchmark. And I think that’s one of the big reasons we’ve been able to generate really some meaningful outperformance over time. But also, you know, first and foremost focused on putting together an underlying allocation that is going to mitigate downside risk and random when you think about what financials did in 2008, it wouldn’t take a rocket scientist to say, hey, I want to be out of the right. And yet a lot of managers just wrote that down, we don’t write things down. So again, that reiterate that whole tactical theme of we’re looking to align ourselves with prevailing market conditions, we’re looking to do it by investing with a relative degree of concentration. And again, if you’re going to stand the chance to outperform if you have an add a significant amount of value for your clients, I really think you need to be sector agnostic. Otherwise, you’re just you’re an index hugger, your closet benchmarking, and you’re in that 90%, for that reason. So it’s very much how we differentiate ourselves in the marketplace.

It just I’ve actually, I found that for a lot of people, tactical investing is what they intuitively expect a manager to be doing for them. And I don’t know that a lot of people understand that that’s actually not what the typical relationship is. And Matt hit on a couple of key points, which is that we have confidence and conviction in what we do actually want to ask you a question here being our Chief Investment Officer, what emboldens Polaris to be willing to act on that conviction and confidence when we don’t see that in most of the the industry as a whole. How do we go into this position, knowing that we can depend on our analytics and know that we’re doing the right thing when it seems like most others aren’t willing to take that next step to to add meaningful portfolio value?

It’s a great question, Jeremy. And I think it kind of boils down to a few different things that that we do, I think it’s very different than than most other firms. For us, it’s all about statistical probabilities. We’re playing a game of math when it really comes down to it. And the the biggest part is to have the odds in your favor. So if you’re sitting there thinking about the average person thinks that investing is like gambling and for them it truly is. So they’re playing a game of blackjack and they don’t understand how many high cards versus low cards have been played. They act shocked when a house when’s the when’s their pot of money. We’re sitting there doing statistical probabilities. And as we see that the level of risk going down for us, we add additional conviction to higher risk investments. And as risk goes up, we try to take some of that risk off the table, either by shifting from high risk or low risk stocks or to take lower positions and equity than we would historically. But from there, I think that probably one of the biggest things out there is ego kills. You know, to me, it’s not about being right, it’s about being right at the right time. And so you can have the greatest ideas on the face of the planet. If the market doesn’t agree with you, you’re wrong. So we don’t fight the Fed, we don’t fight the tape, meaning the direction of the market, we try to check our egos at the door and realize that by doing that, as long as we’re getting more right than wrong, we’re adding value to the situation. But he got he can’t make a mistake into something even bigger, by getting married to a situation and insisting that you’re the smartest person in the room. By doing so that’s a really quick way of being separated from your mind.

Makes sense. And just on a personal note, that’s one of the things that I love the most about Polaris is that you bring that discipline to the table. And I think the results speak for themselves and what we’ve been able to accomplish there.

Appreciate that. So let’s wrap things up with with some lessons learned about, you know, obviously, we’ve been dealing with kind of a crazy year. And looking at that crazy year and what we’re dealing with. Now, tell me what what your biggest takeaway is from this year? how volatile the market is. And if you were to do something differently, with what you know, today, compared to where we were saying early February, what would that be?

So one, and this goes back to the indexing? From my perspective. I mean, the biggest lesson learned, in my opinion is is largely driven by the demographics of this market and the trends and what they’ve been favoring, right, if you’ve seen equity ownership by indices go from 25% to 50%. And, you know, at the rate that it’s been going, and it’s continued, by the way, and an alarming rate this year, right. So what that does is it creates, to me alarming inefficiencies in the market. And I think we saw that earlier this year, in February, and March is the market sold off and sold off. You know, obviously, in a very big way, you saw that correlations essentially went to one with all these stocks, particularly with the larger stocks in the indices, right, because if you spook those index investors, and they control 50% of the assets, you know, those companies are going to sell off in unison. And so that makes it a little harder, or you could argue a lot harder to play defense in those situations, particularly if you’re trying to play defense, or navigate within the mega cap space, because those are the companies that are most greatly influenced by those massive flows. So to me that that would be one of the major lessons learned. And quite frankly, at the same time, I think that opens up significant opportunity for an active management shop, and in particular, a tactical firm taking the approach that we do, right, because we can exploit those inefficiencies in the market, you know, I would pound the table and say, this is really the best opportunity for us going forward is if those inefficiencies continue to exist, we can continue to generate significant alpha for the clients. But to me, that’s it’s one of the biggest lessons learned. It’s why I wrote the article, because it became so evident after seeing that dislocation and and how these trends have impacted. The way you know, we basically have gone away from fundamentals and the market and sentiment and sentiment is really driving quite a bit more, which could be frightening. Right? So, um, but good for us.

That’s a really good point. To answer my own question, kind of going back to that same thing and kind of trying to wrap things up. One of the things you talked about was correlation being one for our listeners to kind of understand that. What correlation is having everything kind of moving together or not moving together, a correlation of one means that there’s you know, everything is moving lockstep together, they’re they’re going up or going down. And at the same rate, which is from a historical standpoint, is not the case. And I think that you’ve kind of, I guess, in a way, stole a little bit of my thunder, what I was going to say, which is the same thing, which, you know, typically we have and half of our strategies, we’re going to go no more than 10% cash and we’re going to move from from high beta to low beta, high risk or low risk. And I keep ourselves fully invested the other half, which, again, has a slightly different tact to it with We’ll go to cash. We also did the same thing we went to cash. But we also probably left a little bit too much money on the table as we move from what we consider to be high risk to low risk. And as I’ve described, you know, baby and bathwater were both thrown out together. In areas of the market that have historically been very low risk, we will talk about the shot index sh, UT. So staples, healthcare utilities and telecommunications are historically the areas of the marketplace that you can run and find shelter, especially in downward markets. And it simply wasn’t the case in February March to what you were saying, Matt? Exactly. We had the fastest drop in the markets history of dropping 30% of his 22 trading days to go down 30 plus percent, which was faster than it was during the Great Depression faster than the 87 stock market crash. We’ve never seen anything quite like it. So we really have dealt with markets that that are truly unprecedented. I really appreciate the insight from both of you, Jeremy, thank you very much for your insight. Matt, thank you for yours. Again, we’ll be back next week with some new and more fun things to talk about. Perhaps elections, perhaps something else but in the interim, be safe, and be healthy. Thank you for listening.

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