Passive vs. Active Portfolio Management: An Overview
Investors have two main investment strategies that can be used to generate a return on their investment accounts: active portfolio management and passive portfolio management.
- Active portfolio management focuses on outperforming the market in comparison to a specific benchmark such as the Standard & Poor's 500 Index.
- Passive portfolio management mimics the investment holdings of a particular index in order to achieve similar results.
As the names imply, active portfolio management usually involves more frequent trades than passive management.
An investor may use a portfolio manager to carry out either strategy, or may adopt either approach as an independent investor.
- Active management requires frequent buying and selling in an effort to outperform a specific benchmark or index.
- Passive management replicates a specific benchmark or index in order to match its performance.
- Active management portfolios strive for superior returns but take greater risks and entail larger fees.
Active Portfolio Management
The investor who follows an active portfolio management strategy buys and sells stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index.
An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers all making investment decisions for the fund. The success of the fund depends on in-depth research, market forecasting, and the expertise of the management team.
Portfolio managers engaged in active investing follow market trends, shifts in the economy, changes to the political landscape, and any other factors that may affect specific companies. This data is used to time the purchase or sale of assets.
Proponents of active management claim that these processes will result in higher returns than can be achieved by simply mimicking the stocks listed on an index.
Since the objective of a portfolio manager in an actively managed fund is to beat the market, this strategy requires taking on greater market risk than is required for passive portfolio management.
Passive portfolio management is also known as index fund management.
Passive Portfolio Management
Passive portfolio management is also referred to as index fund management.
The portfolio is designed to parallel the returns of a particular market index or benchmark as closely as possible. For example, each stock listed on an index is weighted. That is, it represents a percentage of the index that is commensurate with its size and influence in the real world. The creator of an index portfolio will use the same weights.
The purpose of passive portfolio management is to generate a return that is the same as the chosen index.
A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust.
Index funds are branded as passively managed rather than unmanaged because each has a portfolio manager who is in charge of replicating the index.
Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.
Index mutual funds are easy to understand and offer a relatively safe approach to investing in broad segments of the market.