When it comes to investing, there is no one strategy that fits all. Many different situations and circumstances call for different investment strategies, depending on the investor in question. It is important to make sure that as an investor you are vetting and determining which investments will best fit your particular situation, financial goals, needs, risk tolerance and time horizon. Where should you begin your search for the best investment for you?
Most simplistically, investment strategies can be broken down into two specific categories—active investing (active management) and passive investing (passive management). To better understand how each strategy functions and performs over a longer period of time, we’re going to focus on passive investing and active investing separately, then compare the two. By the end of this article, you should be able to discern the potential benefits and pitfalls between the two and apply this knowledge to your own investment portfolio.
What Is Passive Investing?
What exactly is passive investing you ask? It can be defined as an investment strategy that tracks a market-weighted index or portfolio. This strategy is designed to maximize returns over a longer period of time by keeping the trading (buying and selling) to a minimum. With passive management, it is common for investors to mimic the performance of a specific index by buying and holding an index fund. As the investor is directly invested in a specific index, there is a direct correlation between that index and the portfolio's performance. It is important to understand that the investor can expect to perform only as well or as poorly as the index itself. By purchasing and holding onto an index fund, the investor will perform in line with the correlated index with minimal trading and management expenses.
Exchange-traded funds (ETFs) provide a convenient and low-cost opportunity to implement indexing, or passive management. ETFs are available in an extensive variety and they track just about every index in existence. In addition to the vast number of ETFs to choose from, other potential benefits can include low turnover, low cost, no unintended capital gain exposure, broader diversification and a lower expense ratio when compared to its actively managed counterparts.
No matter how enticing passive management may sound, it is vital that you consult with a fiduciary advisor who can help determine whether or not this type of investment strategy is going to fit your financial life. (For related reading, see: Is Passive Investing Effective for Retirement Savings?)
What Is Active Investing?
Now that we’ve learned about the inner-workings of passive investing, we will focus our attention on passive management’s counterpart, active investing (active management). Under this type of investment management, managers take a more proactive approach in an effort to achieve optimal returns and outperform the market.
What is active investing and how does it work? This investment strategy uses the human touch to actively manage an investment portfolio. Managers will utilize analytical research and forecasts, as well as their own investment experience, expertise and judgment in an effort to make the best possible investment decisions regarding what securities to buy, sell or hold. Active managers tend to believe that short-term price movements are significant and that these movements can often be predicted. They are not bound by any single index fund’s performance potential and can deploy a multitude of strategies with the goal of outperforming an investment benchmark index. Some of the strategies used by active fund managers to construct their portfolios include risk arbitrage, short positions, option writing and asset allocation.
Asset allocation may very well be the most conventional strategy. Designing an appropriate asset allocation strategy can lay the very infrastructural baseline that active fund managers and investors alike require in order to achieve superior returns (compared to that of a single index fund).
There are key advantages inherent within active management that may make it a more suitable investment style. One benefit includes the ability to be flexible with one’s investment choice. Practicing active management allows the manager and/or the investor to select different securities from different industries, sectors and asset classes. The flexible nature of active management supplements another major benefit—risk management. (For related reading, see: Active Management: Is It Working for You?)
With an active investment style, one can both increase and/or dial back their risk parameters, as investors have the ability to enter and exit specific holdings or market sectors at an opportune time. Active management can also facilitate one’s ability to manage portfolio volatility. By investing in less-risky, high-quality investments as opposed to investing in the market as a whole, investors can control and help monitor the volatility within a given investment portfolio among all assets classes.
It is very important to note that the cost associated with active investing tends to be higher than passive investing. Frequent trading activity will generate higher transaction costs which can ultimately diminish an investor’s returns. Managers who can add significant value to their portfolio should be in a position to outweigh the increased costs.
The Difference Between Passive and Active Investing
Hopefully you have a working knowledge of both passive and active investing, and are now prepared to compare the two. While some individuals may be best suited for a passive approach, others may find active investing to be a better choice. There are many different components that must be analyzed and assessed before deciding whether actively managed mutual funds or passively managed index funds are the best fit for your own facts, circumstances and financial future.
There is no such investment or strategy that can possibly fit the needs of every investor. An individual that would be best suited by passive investing is someone who is looking for a simple, cost-effective method of investing. As a passive investor, you must be content to perform as well or as poorly as the index. Meanwhile, an active investor believes that portfolio managers can add value to their portfolio by discovering opportunities in the markets that will allow them to outperform their appropriate benchmarks.
When considering active versus passive management there are a couple of key points to consider. Broad-based market index funds make both diversification and asset allocation easy. Comparatively, active investing is far more complex by nature; an actively managed portfolio will tend to have a greater number of investments and to manage such a portfolio requires far more time and expertise. Sometimes portfolio size can be a concern with active investing as too many investments may create overlap which can then cannibalize returns. This is never a concern with passive investing given the fact that this simple method follows the benchmark. (For related reading, see: Active vs. Passive Investing.)
Trading expense is another important component to consider when deciding between passive and active investing. Active investing typically involves a greater amount of portfolio turnover and results in higher costs. Conversely, a passively managed index fund has virtually no buying and selling of securities and therefore, lower costs are evident.
Management expense is another factor that varies between the two investment styles. With passive investing, there are lower operational and management expenses compared to that of active investing. Passive investing is essentially a buy and hold strategy and managing such an investment tends to cost less. Whereas an actively managed portfolio relies on the manager’s ability to outperform and requires the need to do significant research for holdings in the portfolio, making it much more costly. The amount of time and effort to do this successfully will require the manager to receive higher compensation.
Regardless of whether it be passive or active investing, one must always determine their own personal situation prior to making any investment decisions. With the advice and guidance of an experienced fiduciary advisor, one can delineate which strategy best suits them by comparing the complexity, cost, asset allocation and diversification parameters between passive and active management.
(For more from this author, see: The Importance of Rebalancing Your Portfolio.)
Disclosure: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice