Although indexing (a passive investment strategy) has been used by institutional investors for many years, it is still relatively new for the typical individual investor. Because ETFs use predominately passive strategies, the first question any investor should consider is whether to take an active or passive approach to investing. (For more insight, see Active Vs. Passive Investing In ETFs.)
Rationale for Active Investing
The predominant investment strategy today is active investing, which attempts to outperform the market. The goal of active management is to beat a particular benchmark. The majority of mutual funds are actively managed.
Analyzing market trends, the economy and the company-specific factor, active managers are constantly searching out information and gathering insights to help them make their investment decisions. Many have their own complex security selection and trading systems to implement their investment ideas, all with the ultimate goal of outperforming the market. There are almost as many methods of active management as there are active managers. These methods can include fundamental analysis, technical analysis, quantitative analysis and macroeconomic analysis.
Active managers believe that because the markets are inefficient, anomalies and irregularities in the capital markets can be exploited by those with skill and insight. Prices react to information slowly enough to allow skillful investors to systematically outperform the market.
Rationale for Passive Investing
Passive management, or indexing, is an investment management approach based on investing in exactly the same securities, and in the same proportions, as an index such Dow Jones Industrial Average or the S&P 500. It is called passive because portfolio managers don't make decisions about which securities to buy and sell; the managers merely follow the same methodology of constructing a portfolio as the index uses. The managers' goal is to replicate the performance of an index as closely as possible. Passive managers invest in broad sectors of the market, called asset classes or indexes, and are willing to accept the average returns various asset classes produce. (For related reading, see Is Your Portfolio Beating Its Benchmark?)
Passive investors believe in the efficient market hypothesis (EMH), which states that market prices are always fair and quickly reflective of information. EMH followers believe that consistently outperforming the market for the professional and small investor alike is difficult. Therefore, passive managers do not try to beat the market, but only to match its performance. (For background reading, check out What Is Market Efficiency?)
Passive or Active Management – Which is the Best Approach
A debate about the two approaches has been ongoing since the early 1970s. Supporting the passive management argument are the researchers from the nation's universities and privately funded research centers. Wall Street firms, banks, insurance companies and other companies that have a vested interest in the profits from active management support the other side of the argument.
Each side can make a strong logical case to support their arguments, although in many cases, the support is due to different belief systems, much like opposing political parties. However, each approach has advantages and disadvantages that should be considered.
Active Management - Advantage/Disadvantage
The main advantage of active management is the possibility that the managers will be able to outperform the index due to their superior skills. They can make informed investment decisions based on their experiences, insights, knowledge and ability to identify opportunities that can translate into superior performance. If they believe the market might turn downward, active managers can take defensive measures by hedging or increasing their cash positions to reduce the impact on their portfolios.
A disadvantage is that active investing is more costly, resulting in higher fees and operating expenses. Having higher fees is a significant impediment to consistently outperforming over the long term. Active managers, in an attempt to beat the market, tend to have a more concentrated portfolio with fewer securities. However, when active managers are wrong, they may very significantly under-perform the market. A manager's style could be out of favor with the market for a period of time, which could result in lagging performance.
Passive Management - Advantage/Disadvantage
The main advantage of passive investing is that it closely matches the performance of the index. Passive investing requires little decision-making by the manager. The manager tries to duplicate the chosen index, tracking it as efficiently as possible. This results in lower operating costs that are passed on to the investor in the form of lower fees.
A passively managed investment will never outperform the underlying index it is meant to track. The performance is dictated by the underlying index and the investor must be satisfied with the performance of that index. Managers are unable to take action if they believe the overall market will decline or they believe individual securities should be sold.
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