Imagine you are an aeronautical engineer, on a team competing for a design contract for a new airliner. You are designing what will be a new fleet of airplanes intended for commercial air travel. Your goal is to get many travelers to their destinations safely and on time.
In your design considerations, you have a choice of component parts. One group of parts is generic, the other is custom-made. The generic parts behave exactly as they are expected to behave and perform very consistently in relative terms to their intended purpose.
The custom-made parts vary wildly in performance; some perform appreciably better than they are supposed to while others woefully disappoint. The result is that some airplanes made with the custom parts will arrive ahead of schedule and many will arrive late.
You can also look at the historical performance of each of these parts, but you cannot reliably predict how they will perform in the future. The custom-made parts are also more expensive to buy and maintain. The bottom line, statistically, is that the cost/performance ratio of the custom-made parts is lower than the generic group.
WHICH GROUP OF COMPONENTS WOULD YOU CHOOSE?
This is the essence of the decision between active and passive (asset-class) investing. Actively managed portfolios are like airplanes made with custom parts. Some will perform better and others will perform worse than the portfolios constructed with generic components (index funds, broad-market ETF’s, and other strategies designed to capture the returns of an asset class, rather than seeking to out-perform).
As professional investment advisors, we have to build in as much predictability into our clients’ portfolios as we can. While we cannot predict the market, if we use asset-class type investment strategies we can rely on the relative performance of the components of our portfolio (the market is an externality that affects results, much like the weather in aviation, over which we have no control once the airplane is in the air).
If instead, we build a portfolio using actively-managed components, we always have the potential to do better (and for any time period some will always do better) but in reality, because of higher costs, the average portfolio will do worse. This is why the greater portion of our portfolios will be composed of lower cost asset class strategies.