Updated: Sep 30, 2022
Active Vs Passive Management
There has been a longstanding debate on the active vs. passive style of investing. While there has been unprecented growth in passive investing, here we will look at the benefits of both styles of investing.
Active management involves professional money managers monitoring and making decisions about investments in a portfolio. Of whether to buy, sell or hold. As opposed to passive investing that requires minimal to no management of assets. The portfolio mirrors major indices such as the Dow Jones or the S&P 500 index, and, until recently, most Exchange Traded Funds (ETFs) are passively managed investments.
Active management relies on research and analysis. And the judgment and experience of money managers in making decisions on a portfolio. Whereas, passive investing relies on the belief that stock markets are highly efficient – that stocks trade at their intrinsic value. And as a result, it isn’t easy to outperform the stock market.
Active managers don’t believe that markets are efficient. And that stock prices don’t always reflect their actual value. That investors are irrational. This, and the fact that economic conditions play a crucial role in affecting stock prices.
And it’s through analysis that managers can identify opportunities and outperform the markets.
There are many benefits to the active style of managing a portfolio.
The stock market is “capitalization-weighted.” Larger, more valuable companies have more of an effect on how the market performs than smaller, less valuable companies. So, when you invest in an S&P 500 index fund, you invest in the 500 stocks in that index in proportion to each company’s relative value, which means that you may be overweight in the largest companies. This may result in more risk and greater volatility.
An actively managed portfolio has greater flexibility in security selection. An active manager may decide to reduce the volatility and risk of a portfolio by regularly rebalancing it. Instead of being overweight in the largest market capitalization stocks, he may sell off stocks that have significantly appreciated in a short time. Depending on the mandate, an actively managed portfolio manager may even decide to keep a portion of a portfolio in cash. It is this flexibility that lowers risk.
Take Advantage of Opportunities
Active management of a portfolio allows managers to seize opportunities should they arise. Where passive investing would be heavily weighted with large, capitalized companies in the stock index, active managers can purchase smaller, less valuable companies, which are temporarily out of favor for one reason or other.
Fixed Income Markets
Passive Investing such as Index funds means that the fund mirrors the index. In the fixed income market, such as the corporate bond market, the largest corporate debt holders are the most prominent players in the market. This may cause the index to be higher risk than necessary. An active manager can be selective about what is held in the fixed income space and reduce exposure to corporations with excessive debt.
Less Efficient Markets
The ‘efficient market’ hypothesis may not apply to all stock markets. Not all stock markets have the same degree of transparency and efficiency as North American markets. Developing economies are a good example. And what about new issues? Not all sectors and asset types are reflected in major indices. Passive investing does not cover all available securities. Cryptocurrency is one example. Newly emerging sectors may not appear in passive investments till they get greater significance in the markets. Active managers can spot these are investing in these newly emerging sectors.
With greater flexibility, active managers can adopt defensive strategies in their security selection in response to economic changes. They are also able to respond quicker by selling off poor-performing positions. With passive investing, you’re in for the ride – moving the way the market moves. If a particular stock is doing poorly for a long time but still sits in the market, passive investing leaves you with little choice. An active manager has the option to sell off poor performers.
Many financial institutions provide actively managed portfolios customized to an individual’s investment preference, return objectives, and risk tolerance. Usually, this is offered to high-net-worth clients.
Active vs. Passive
Active management aims to outperform the major indices such as the Dow Jones or the S & P 500. Yet, the most significant criticism of active management is that it rarely does that.
The latest SPIVA (S&P Indices Versus Active Funds) report shows that for the twenty years ending Dec 31st, 2020, 86% of active manages underperformed the indices of all domestic funds.
There are many reasons for their underperformance.
One of the biggest criticisms about actively managed funds is the fees. Actively managed funds charge higher fees than passive funds, making sense since it is to pay the portfolio managers. The management fees in most actively managed funds range from about 1 to 2.5%. These fees eat into the performance of the portfolio. They make it difficult to outperform the index. Over time this can make a significant impact on the overall performance of a portfolio. If the fees are significantly reduced as they have been with Vanguards actively managed funds, the returns are more comparable. The average Vanguard fund expense ratio is 83% less than the industry average.
Active managers may be more inclined to take lesser risks than the broader index – to protect client assets. At least in the short term. This aversion to risk comes with a price tag – lower returns.
Active managers may be reluctant to hold on to securities in bear markets. Long periods of downtown can be discouraging to the investor, who may not wait for the full recovery. The pressure for short-term results may cause active managers to make changes in the portfolio that do not benefit it in the long run. Mutual Funds that have employed all the benefits of the active management style and consistently outperformed the stock market include The Baron Partners Retail BPTRX. It has had an average return of 23.71 over the past ten years. It is beating the S&P 500, which has returned 13.88%.
And the Morgan Stanley Insight 1 CPODX has made an average annualized return of 23.51% over the past ten years. An average of 10% more than the S&P 500. Vanguard PRIMECAP Fund is another excellent example of a well-managed fund. With a management expense ratio of 0.4% and a strategy of buying out-of-favor growth companies and holding them for a decade, The Vanguard PRIMECAP Fund beat the S&P 500 by an average of 3 percentage points per year over the last 15 years! It is necessary to mention at this point that past performance is no indicator of future performance.
What should investors do? It all comes down to the level of risk investors are willing to take. An active manager with a defensive strategy may result in a less volatile portfolio than the index. Some investors are willing to trade returns for less volatility. If you want a high level of diversification, passive investing may be the way to go since you are getting exposure to the broad market.
Passive investing is for the long haul. It can also make for a good core holding in a portfolio. If you are not someone who takes a keen interest in investing, then passive investments are a great option. You can’t do much worse than the markets.
To get the best of both worlds, diversify by holding both passive and active funds. It is difficult for managers to outperform the S&P 500, so an S&P index fund or ETF would be a good investment to hold. Compliment with actively managed funds with different mandates, sectors, and management styles, such as health care or high-tech funds. The two different approaches would hold you in good stead over the long run.
More importantly, investing should align with your risk tolerance and personal objectives. An index fund may not be able to do that thoroughly. And not through all stages of your life. While you’re young, with a good income and a long-term investment horizon, growth should be your dominant focus. You have the time to withstand market volatility; as you enter retirement, it may be beneficial to have a more hands-on approach to your investments—a regular rebalancing of the various asset classes represents your changing income requirements.
Many actively managed funds provide this rebalancing within their mandate, which lowers volatility. And as you start to draw from your investments to pay for your lifestyle, you will appreciate having a segment of your portfolio in cash, fixed income, and lower-risk assets. In the passive investing space, you have money market funds with little risk. However, you may be able to find other investments like term deposits offering little risk with a slightly better return than money market funds.
You want to avoid a situation of having all your investments in passive investments offering little flexibility.
The potential to outperform
Passive investing does not outperform the markets it is mimicking. Having money in active investments allows you the possibility of outperforming the markets. There are still many active money managers who consistently outperform the markets. With many fund companies now offering competitive management fees, why not take advantage of that?
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