Money can be managed inside a mutual fund in a number of different ways; however, all of them will fall into one of two categories: actively managed versus passively managed accounts. In active management, an individual or a team of individuals does the research, makes the investment decisions and selections, and puts investments into the fund. For passively managed accounts, a computer does the buying and selling based on an index.

Recently, passive mutual funds have grown in popularity and the trailing performance of passive or index funds has outperformed active management to a very large extent. This is driving more investors to the world of passively managed investments.

In my opinion, there are certain areas of an asset allocation where there is real danger to blindly investing in passive investments. The dangers lie with the conservative side of the portfolio, which is even bigger for someone in retirement.

As advisers, we typically invest in bonds on the conservative side of the portfolio. The traditional bond that ends up in a portfolio is investment grade, high quality, corporate or government. These are extremely liquid, so a passive fund is acceptable. However, the bond market is extremely different from the stock market and if you start using a passive or index fund for some of the more fringe categories of bonds, such as junk bonds, floating rate bonds, international bonds or convertible bonds — there is potential for trouble.

‘The undesirables’

For example, if you want to invest in an energy stock fund, you can pick an energy stock index fund. You’re going to have the same activity in your portfolio as everyone else that’s buying an energy fund. Active or passive, there shouldn’t be a gigantic difference. However, if you’re going to invest in an energy bond, an energy company might have 200 different kinds of bonds. They will have different covenants that affect their value. Those can be very high risk if you’re going to be investing in them. In this case, you’ll want someone that’s doing the appropriate credit analysis and that understands what they’re buying and why they’re buying it. This is active management. In a higher risk bond fund, you want to own bonds for a reason.

If you were to invest in an index or a passive fund that’s buying the same higher risk bond types, no one is doing any of the research or credit analysis. It is a computer that’s essentially blindly buying bonds to try and reconstruct an index. Imagine what will be bought for this this passively managed fund. If all of the desirably inventory has been purchased for the actively managed funds, what gets purchased is the leftovers. The undesirables. If interest rates start rising and the bond market goes into a correction, the demand for those types of bonds — the leftovers that no one wanted, which end up in a passive fund — could dry up and values could decrease quickly.

I believe, it is safer to use active management for this part of the portfolio. If you want high yield bonds and fringe bonds which most people agree are important, higher a competent manager that is buying bonds for a reason. When we’re building a portfolio for a retired client, we’re almost never using a passive fund for some of those outlying bond asset classes that are important.

The quality of management is a key component of a successful financial plan, especially for those that have shorter time horizons like retirees. The desire for advisors to recommend things that are low cost and have good trailing performance are missing an important risk to which they may be exposing their clients.

Baldwin, CFP, is vice president of Spencer Financial, LLC in Sudbury, Mass., and an investment adviser representative of Signator Investors, Inc. He is an eight-year member of the Million Dollar Round Table (MDRT) with four Court of the Table qualifications.

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