How to Use Active and Passive Investing for Retirement

June 27, 2016 — 4:24 PM EDT

Passive management through buying and holding low-cost funds is the most widely recommended investment strategy for retirement. This option makes sense for the typical investor, because it doesn’t require advanced investing knowledge or take a lot of time, can help minimize emotion-based investment decisions, and ensures that investment fees don’t significantly reduce investment returns. In addition, passively managed funds generally outperform their actively managed counterparts, especially over longer time periods.    

While passive investment might seem like the clear winner, E-Trade finds, in its most recent quarterly survey of experienced investors, that “three out of five investors prefer an approach that combines active and passive management.” These investors look to active management “to seek outperformance in narrower and less liquid segments of the market.” The survey respondents were 907 self-directed active, passive and swing investors who manage at least $10,000 in an online brokerage account.

Indeed, active management might have a place in a retirement portfolio for certain types of investments and certain types of investors.

When Does Active Make Sense?

Konrad Brown, a wealth advisor at United Capital Financial Advisers in Fort Lauderdale, Fla., says that an actively managed fund makes sense in volatile markets because these conditions create better opportunities for an active manager to identify mispriced securities that can outperform an index. Active managers believe that markets are not inherently efficient.

Investment manager Brian Sterz of Miracle Mile Advisors says that active management is best suited for markets where information and analysis are more difficult to attain, such as U.S. small-cap stocks, emerging-market stocks and fixed-income and high-yield bonds. Specialists in these asset classes may have a better chance of outperforming their benchmarks after investment fees. Very-low-fee passive management makes more sense for U.S. large-cap stocks, for which active managers are unlikely to do better.

Because actively managed funds are less tax efficient, have higher fees and have historically underperformed passive funds over the long term, investors with a large amount of assets to invest, a long time horizon, a high risk tolerance and a deep understanding of financial markets are best suited for active management, according to Brown. He believes that active management should be left to professional portfolio managers – it’s not a DIY endeavor.      

“Passive funds tend to do well in periods of market prosperity. They capture the gains of a bull market with a fraction of the fees,” says Brown. But when markets become stagnant or go south, an active strategy may offset poor market performance. Both active and passive strategies can be used in tandem in an investor’s portfolio, notes Brown. (For more, see Retirement Strategy: Should You Be Buying More Stocks?)

How to Choose an Active Manager

“Over short periods of time, it’s hard to distinguish between a manager’s skill and luck,” says Simon R.B. Hamilton, managing director at the Wise Investor Group at Robert W. Baird & Co., a full-service investment firm located in Reston, Va. Investors should look at the manager’s track record through both bull and bear markets and especially over multiple tough periods. Investors should also look at returns for more than just the last five years and read the manager’s annual letter and quarterly commentaries. Find out whether the active manager you’re considering has a well-thought-out, disciplined investment process and long-term philosophy and isn’t just all about what’s working in the present conditions, advises Hamilton.

Chartered financial analyst Ben Malick of Three Nine Financial, a financial planning and investment management firm based in Grain Valley, Mo., said investors should look for a portfolio management team that has significant skin in the game and should avoid the many funds that are closet indexers, meaning those that don’t deviate far from their stated index. “Instead, look for portfolio managers who act on their convictions by taking more concentrated positions,” says Malick. “After all, that’s what you’re paying them for.”

There is no shortage of extremely smart and talented active fund managers, says Nathan Geraci, president of the ETF Store, a full-service investment advisory firm based in Overland Park, Kan., that focuses on using low-cost, index-based ETFs in its clients’ portfolios. The challenge lies in translating that intellect into investment outperformance, and that’s where active managers consistently come up short for several reasons.

Active managers must overcome their management fees, which averaged 0.86% for stock equity funds in 2014 compared with 0.11% for index equity funds and index bond funds, which are passively managed. They have trouble outperforming over the long run. (For more, see Could Your Retirement Portfolio Handle Another Financial Crisis?)

Morningstar’s Active-Passive Barometer finds that “higher-cost funds are more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success.” Among large-growth U.S. stock funds, “roughly half the active funds that existed in this category 10 years ago survived the decade, and just 12.2% managed to both survive and outperform their average passively managed peer,” finds Morningstar.   

Similarly, according to the S&P Persistence Scorecard, which looks at the performance over time of actively managed domestic U.S. equity funds, “relatively few funds consistently stay at the top. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015.” Further, “no large-cap or mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period,” states the S&P report. 

Geraci says the allure of active management versus indexing lies in the potential for market outperformance. While most active managers don’t consistently outperform, for investors who wish to pursue this possibility, the most important factor to consider is fund fees, as there is a direct relationship between fund fees and fund performance. (For more, see Picking Retirement Stocks: Dividends vs. Free Cash Flow.)

The Bottom Line

For most investors, sticking with a passive strategy for retirement investing will probably result in the best long-term returns, as long as investors choose low-cost funds, diversify their portfolios and use a buy-and-hold strategy. For investors who can afford to gamble with a portion of their retirement savings, don’t mind doing extra research and think they can pick a manager who can outperform the market in the long run, active management might have a place in their portfolios. (For more, see Diversification: Your Best Retirement Planning Tool.)