The first investment decision that most investors make is choosing between active and passive strategies. Active strategies involve selecting assets and then making frequent readjustments to the portfolio. The goal of an active strategy is to outperform a market index. Passive strategies, on the other hand, seek to match the market performance, which is accomplished by creating a portfolio that mimics a market index.
The type of asset has a major impact on the strategy’s success. Passive strategies work well for portfolios of large cap stocks or investment grade bonds. Due to being widely held, beating the market using these assets is difficult. In contrast, lesser known assets such as small cap stocks and alternative assets are better choices for active strategies. Information is less readily available for these assets and there are opportunities to capture value through superior analysis.
When deciding between active and passive strategies, investors should take costs into account. Actively managed investments tend to have higher management fees compared to passively managed investments. For retirees transitioning to a conservative portfolio with more fixed income exposure, high management expenses can be problematic. An actively managed bond portfolio that generates returns of 3-4% a year and has a 1% expense ratio would lose a quarter of annual return just in management fees.
Alternatively, passive investments have smaller fees and are typically more tax efficient due to less portfolio turnover. This tax benefit is important for individuals who enter retirement with substantial assets in taxable accounts. Taxes are higher on actively managed portfolios as a result of frequent trading, which generates short-term capital gains and losses.
Passively managed investments are characterized by greater simplicity. After the benchmark portfolio is created, there is little need for ongoing monitoring. Management changes and similar events wouldn’t affect the strategy. This simplicity is appealing to retirees who don’t want to spend much time monitoring their investments. If a passively managed portfolio needs rebalancing, allocations can be easily changed to achieve the targeted asset mix.
Meanwhile, the principal advantage of an actively managed portfolio is the ability to make frequent readjustments. This reduces exposure to market sectors that appear overpriced and boosts exposure to underpriced sectors that could potentially increase in value.
Actively managing a real estate investment is usually accomplished through property acquisitions and divestitures while deciding between fix-and-flip properties and rentals. Active strategies require a high degree of involvement by the investor. Much time is spent researching neighborhoods, selecting properties, securing financing, overseeing renovation work and marketing the finished product.
The main advantage of actively managing a real estate investment is better control of the process. The investor selects the neighborhood, the type of property (i.e. single or multi-family residential, commercial, or new development) and the amount of capital to invest. However, the principal drawback associated with active strategies is the time and effort required. Renovating properties can take months. Rentals may be less time-consuming since the investor has the option of hiring a property manager, but outside management is expensive. For their services, property management firms typically charge 8% to 12% of the property’s monthly rental income, plus expenses.
Active strategies usually require a sizable financial commitment as well. Fix-and-flip lenders often demand a 20% down payment from the investor, plus personal guarantees of the loan. With an average home costing around $200,000, a fix-and-flip investor would need to supply $40,000 upfront, even before considering closing, renovation, taxes and utility costs.
Passive strategies for real estate usually involve owning REITs and real estate mutual funds or investing in private equity deals. No real estate expertise is required and the demands made on the investor’s time are minimal. However, the investor has no control over the assets being added or subtracted from the portfolio and no input on the strategy.
Mortgage pool funds are a type of real estate investment that combines the best aspects of passive and active strategies. Funds may have either a national or regional lending focus and specialize in certain types of properties. Mortgage pool funds resemble an actively managed product in that individuals can choose the niche markets and property types they prefer. In addition, individuals have control over the size of the investment. Most mortgage pool funds require only a $25,000 initial investment. Mortgage pool funds also limit investment to a few hundred subscribers, which means that fund holders have access to managers to discuss strategies and assets.
Mortgage pool funds also offer many of the advantages of passive investing. The lending portfolio is professionally managed. Fund administrators handle all of the paperwork. Investors simply sit back and collect their dividends, which they may opt to receive monthly. The investing process is transparent and relatively simple. Management fees are a modest percentage of fund returns since most mortgage pool funds consistently return at least 7-9% annually to investors. Choice, simplicity, ease of investing and low expenses make mortgage pool funds a great combination of active and passive real estate investing.