For many years, the differences in strategies between active and passive investing has turned into a heated debate among investors, wealth managers, and portfolio managers. An active investment strategy entails funds run by investment managers who are trying to outperform a certain index, i.e. the S&P 500 or Russell 2000, over a period. A passive investment strategy, on the other hand, includes funds that intend to match the performance of an index. Both strategies have their advantages and disadvantages. Below is a brief description of each strategy, along with pros and cons to each.
Passive investing is a strategy intended to match, not beat, the performance of a specific index or benchmark. Generally, passive investment strategies are automated with some human oversight. Fees and expenses of passive investing are typically much lower than those of active investing. Passive investors “time” the market less and are invested for the long haul. Passive investing, otherwise known as the buy-hold strategy, is typically much more cost-effective than active investing. Passive investors, however, must resist the urge and temptation to react or anticipate an asset’s next move. The most successful passive investors stay focused on their final goals and ignore any short-term or sharp market downturns.
PROS:
- Significantly Lower Fees: Since there is little stock picking, little oversight is needed to manage your portfolio. Passive investing typically follows an index as their benchmark and additional costs are minimized when an investor isn’t constantly buying and selling in the portfolio.
- Tax Efficiency: The buy-and-hold strategy typically results in less investment-related tax consequences as a result of less trading activity in the portfolio.
- Lower Tracking Errors: With this hands-off approach, limiting short-term buying and selling and allowing for portfolio diversification and low-cost trading limits your investment risk.
Cons:
- Limited Selection: Passive investors typically follow specific indices, which have little to no variance. Passive investors typically are locked into their holdings, regardless of what occurs in the markets.
- Returns Relative to the Benchmark: Passive investing, by definition, may rarely beat the market, even in times of market uncertainty and volatility as their investments are intended to follow the market.
Passive investment strategies have become more and more prevalent among many investors, portfolio managers, and investment strategists over the past ten years. Below is a graph showing the cyclical nature of both passive and active performance trends.
Active investing is a strategy intended to outperform a specific index or benchmark and is managed by human portfolio managers and analysts. The main goal of active investing is to “beat” the stock market and reap the rewards of short-term price fluctuations. Active portfolio managers must use deeper analysis and expertise of stocks, bonds, and other assets to accurately pivot in and out of said asset. Successful investors are typically “right” more often than “wrong” when buying and selling a particular asset. Although active investments may sometimes provide greater returns, both risks, fees, and expenses associated with active management may also increase, which could hamper overall performance and returns.
PROS:
- Flexibility in Assets: Active investment strategies allow for the investor or portfolio manager to individually research an asset and buy and sell with relative ease.
- Hedging: Because of the ability to quickly move in and out of positions, active managers can hedge their bets using various techniques, such as short sales or put options.
- Tax Management: Although active investing may lead to capital gains tax, active managers can tailor tax management strategies to individual investors, utilizing strategies such as tax-loss harvesting.
CONS:
- Expensive: Higher fees are typically associated with active investment managers as a result of increased trading activity. These fees may also eat away at any potential investment returns.
- Higher Risk Strategy: Because active investment managers typically buy and sell based on their own analysis and market timing, wrong predictions may potentially lead to greater losses.
Utilizing both active and passive investment strategies for diversification purposes may offer good portfolio solutions along with the ability to meet each client’s unique risk and return objectives. Long-term investing, and those who don’t give in to the temptation of short-term market fluctuations and investing opportunities due to extreme volatility, may reap greater rewards over the course of an investor’s lifetime. Historically, long-term investors are more likely to have a higher rate of success than short-term investors.
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