One of the longest-standing debates in investing is over the
relative merits of active portfolio management versus passive management. With
an actively managed portfolio, a manager tries to beat the performance of a
given benchmark index by using his or her judgment in selecting individual
securities and deciding when to buy and sell them. A passively managed
portfolio attempts to match that benchmark performance, and in the process,
minimize expenses that can reduce an investor’s net return. Each camp has
strong advocates who argue that the advantages of its approach outweigh those
for the opposite side.

Active investing: attempting to add value

 

Proponents of active management believe that by picking the
right investments, taking advantage of market trends, and attempting to manage
risk, a skilled investment manager can generate returns that outperform a
benchmark index. For example, an active manager whose benchmark is the Standard
& Poor’s 500 Index (S&P 500) might attempt to earn better-than-market
returns by overweighting certain industries or individual securities, allocating
more to those sectors than the index does. Or a manager might try to control a
portfolio’s overall risk by temporarily increasing the percentage devoted to
more conservative investments, such as cash alternatives.

 

An actively managed individual portfolio also permits its
manager to take tax considerations into account. For example, a separately
managed account can harvest capital losses to offset any capital gains realized
by its owner, or time a sale to minimize any capital gains. An actively managed
mutual fund can do the same on behalf of its collective shareholders.

 

However, an actively managed mutual fund’s investment
objective will put some limits on its manager’s flexibility; for example, a
fund may be required to maintain a certain percentage of its assets in a
particular type of security. A fund’s prospectus will outline any such
provisions, and you should read it before investing.

 

Passive investing: focusing on costs

 

Advocates of unmanaged, passive investing–sometimes referred
to as indexing–have long argued that the best way to capture overall market
returns is to use low-cost market-tracking index investments. This approach is
based on the concept of the efficient market, which states that because all
investors have access to all the necessary information about a company and its
securities, it’s difficult if not impossible to gain an advantage over any
other investor. As new information becomes available, market prices adjust in
response to reflect a security’s true value. That market efficiency, proponents
say, means that reducing investment costs is the key to improving net returns.

 

Indexing does create certain cost efficiencies. Because the
investment simply reflects an index, no research is required for securities
selection. Also, because trading is relatively infrequent–passively managed
portfolios typically buy or sell securities only when the index itself
changes–trading costs often are lower. Also, infrequent trading typically
generates fewer capital gains distributions, which means relative tax
efficiency.

 

Note:
Before investing in either an active or passive fund, carefully consider the
investment objectives, risks, charges, and expenses, which can be found in the
prospectus available from the fund. Read it carefully before investing. And
remember that indexing–investing in a security based on a certain index–is not
the same thing as investing directly in an index, which cannot be done.

 

Blending approaches with asset allocation

 

The core/satellite approach represents one way to employ
both approaches. It is essentially an asset allocation model that seeks to
resolve the debate about indexing versus active portfolio management. Instead
of following one investment approach or the other, the core/satellite approach
blends the two. The bulk, or “core,” of your investment dollars are kept in
cost-efficient passive investments designed to capture market returns by
tracking a specific benchmark. The balance of the portfolio is then invested in
a series of “satellite” investments, in many cases actively managed, which
typically have the potential to boost returns and lower overall portfolio risk.

 

Note:
Bear in mind that no investment strategy can assure a profit or protect against
losses.

 

Controlling investment costs

 

Devoting a portion rather than the majority of your
portfolio to actively managed investments can allow you to minimize investment
costs that may reduce returns.

 

For example, consider a hypothetical $400,000 portfolio that
is 100% invested in actively managed mutual funds with an average expense level
of 1.5%, which results in annual expenses of $6,000. If 70% of the portfolio
were invested instead in a low-cost index fund or ETF with an average expense
level of 0.25%, annual expenses on that portion of the portfolio would run $700
per year. If a series of satellite investments with expense ratios of 2% were
used for the remaining 30% of the portfolio, annual expenses on the satellites
would be $2,400. Total annual fees for both core and satellites would total
$3,100, producing savings of $2,900 per year. Reinvested in the portfolio, that
amount could increase its potential long-term growth. (This hypothetical
portfolio is intended only as an illustration of the math involved rather than
the results of any specific investment, of course.)

 

Popular core investments often track broad benchmarks such
as the S&P 500, the Russell 2000® Index, the NASDAQ 100, and various
international and bond indices. Other popular core investments may track
specific style or market-capitalization benchmarks in order to provide a value
versus growth bias or a market capitalization tilt. While core holdings
generally are chosen for their low-cost ability to closely track a specific
benchmark, satellites are generally selected for their potential to add value,
either by enhancing returns or by reducing portfolio risk. Here, too, you have
many options. Good candidates for satellite investments include less efficient
asset classes where the potential for active management to add value is
increased. That is especially true for asset classes whose returns are not
closely correlated with the core or with other satellite investments. Since
it’s not uncommon for satellite investments to be more volatile than the core,
it’s important to always view them within the context of the overall portfolio.

 

Tactical vs. strategic asset allocation

 

The idea behind the core-and-satellite approach to investing
is somewhat similar to practicing both tactical and strategic asset allocation.

 

Strategic asset allocation is essentially a long-term
approach. It takes into account your financial goals, your time horizon, your
risk tolerance, and the historic returns for various asset classes in
determining how your portfolio should be diversified among multiple asset
classes. That allocation may shift gradually as your goals, financial
situation, and time frame change, and you may refine it from time to time.
However, periodic rebalancing tends to keep it relatively stable in the short
term.

 

Tactical asset allocation, by contrast, tends to be more
opportunistic. It attempts to take advantage of shifting market conditions by
increasing the level of investment in asset classes that are expected to
outperform in the shorter term, or in those the manager believes will reduce
risk. Tactical asset allocation tends to be more responsive to immediate market
movements and anticipated trends.

 

Though either strategic or tactical asset allocation can be
used with an entire portfolio, some money managers like to establish a
strategic allocation for the core of a portfolio, and practice tactical asset
allocation with a smaller percentage.

 

Note:
Asset allocation and diversification are methods used to help manage investment
risk; they do not guarantee a profit or protect against investment loss.

 

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advisory group that specializes in transition planning and lump sum
distribution. Please call our office at 800-900-5867 if you have additional
questions or need help in the retirement planning process.

 

This material was prepared by Broadridge Investor
Communication Solutions, Inc., and does not necessarily represent the views of
The Retirement Group or FSC Financial Corp. This information should not be
construed as investment advice. Neither the named Representatives nor
Broker/Dealer gives tax or legal advice. All information is believed to be from
reliable sources; however, we make no representation as to its completeness or
accuracy. The publisher is not engaged in rendering legal, accounting or other
professional services. If other expert assistance is needed, the reader is
advised to engage the services of a competent professional. Please consult your
Financial Advisor for further information or call 800-900-5867.

 

The Retirement
Group is a Registered Investment Advisor not affiliated with  FSC Securities and may be reached at
www.theretirementgroup.com.

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