Active vs. Passive Investing: How Should You Invest?
Why It Matters:
- These fundamental strategies should guide overall investment decisions
- Active and passive strategies present varying levels of risk, reward, and fees
- Knowing the difference means you can have informed discussions with your advisor
Are the funds in your portfolio actively managed or passively managed? Do you know? If you don’t, a quick course could help you make investment choices that better suit your needs.
The active versus passive investment debate is a conversation economists and financial professionals have been having for a while. Some draw a hard line, sticking with one strategy or the other, regardless of the client. But if you’re working with an advisor, your needs should determine the strategy, not their personal preferences. Let’s talk about each option so you can have better conversations with your advisor.
What’s a fund again?
Before we get into actively and passively managed funds, a refresher on mutual funds and exchange traded funds (ETFs) might be helpful. In a nutshell, both provide opportunities to purchase an interest in large pools of securities for less money than it would cost to buy each individual security in the pool.
The main difference is mutual funds can be traded once a day, after the markets close, whereas ETFs can be traded throughout regular trading hours — meaning there is a difference in liquidity of the funds. Whether you purchase mutual funds or ETFs, you still have the opportunity to decide between actively and passively managed funds.
Active investing may be what you typically think of when it comes to investing. In an actively managed fund, the manager chooses individual securities from an asset class and determines the amount of those securities to buy in an attempt to generate higher returns than a stated benchmark in the same asset class. Many times the benchmark will be an index that tracks the asset class, like the Standard & Poor’s 500® (S&P 500). If tracking the S&P 500, the fund’s manager will purchase large-cap securities that he or she thinks will beat the performance of the S&P 500. Investors in an actively managed fund are not only buying the fund’s assets, but also the fund manager’s expertise, which could prove to be valuable.
The steep rise in the popularity of passive investment strategies is a recent phenomenon, appearing largely over the past two decades.1 Passive fund managers also use a benchmark to measure success, but they try to mimic that benchmark, rather than outperform it. If we use the S&P 500 example again, the passive manager would simply buy the securities tracked by the S&P 500 in like proportion to the weighting of the index. Passive management is based on the theory that market prices always reflect the true value of a security, meaning there is no way to beat the market.2 Passive investors are typically looking for an affordable way to purchase a large pool of securities, not necessarily a fund manager’s knowledge, because the manager of a passive fund isn’t doing a lot of analysis.
Knowing what’s right for you
There are pros and cons to active and passive strategies. Like all investment decisions, choosing the right strategy depends on your investment objectives. Active management is preferable for certain asset classes. For example, over the past 10 years, actively managed small‐cap funds focused on developed markets outside North America have done better than their passively managed counterparts roughly 85% of the time.3 Likewise, in recent years, the median active bond manager has outperformed the median passive bond manager by more than 50 basis points.4
If fees are a primary concern, passive investments might be a better option. But remember, you get what you pay for, and sometimes a watchful eye on the markets is worth the expense. The bottom line is it’s important to understand how these strategies work so you can make the best decisions about where to place your investments.
Things to Consider:
- Talk to your advisor about which strategy they use and if they use both
- Keep an eye out for key words like “index” or “growth” to know which funds you’re buying
- Before investing, consider how the assets you’re buying perform under both strategies
1 "The Shift from Active to Passive Investing: Potential Risks to Financial Stability?", Finance and Economics Discussion Series 2018-060. Washington: Board of Governors of the Federal Reserve System, 2018
2 "Stock Market Strategies: Are You an Active or Passive Investor?", Scott Wolla, St. Louis Fed, 2016
3 "Here's Where Active Management Actually Works," Institutional Investor, April 2019
4 "Bonds are Different: Resolving the Active vs. Passive Debate," PIMCO, 20187
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