There are a number of investing decisions that you face in putting together your investment portfolio. Active versus passive investing is one of those decisions. Here are some of the aspects of both investing styles, including the differences, that you should be aware of.
What is passive investing?
Passive investing is more of a buy and hold approach. The goal of passive investing is generally to match the performance of a market index, such as the S&P 500, the Russell 2000 and others. Index mutual funds and ETFs have emerged as a major investing vehicle for both individual and professional investors.
Index funds and ETFs have become popular as many of them have outperformed their actively managed peers in recent years. Combine this with their generally lower expenses and you have a winning combination for many investors.
Index funds are professionally managed. The manager will devise a methodology to replicate the performance of the fund’s benchmark index over time. Index funds rebalance their holdings to match the weightings of the various securities in the index periodically. This may be monthly, quarterly, semi-annually or in some cases more frequently. This infrequent trading is a prime reason for the lower expenses of index mutual funds and ETFs.
What is active investing?
Active mutual funds and ETFs attempt to outperform the stock or bond index that is the benchmark for their fund. Actually managed mutual funds are more common than actively managed ETFs.
Active investors buy and sell securities based on their investment strategy as well as their belief that the security will outperform or underperform the market over a period of time. The goal of active investing is to beat the market, not to match the performance of a market index.
Active managers and individual investors will make investment decisions based on a variety of factors including market trends, economic factors, factors that are unique to a particular stock or bond and many others.
Differences between active and passive investing
As discussed above, the main difference between active and passive investing is that active investing involves a more hands-on approach to investing. Active investors typically perform in-depth analysis of the securities that they are buying and selling. Passive investors do not engage in this type of analysis of individual stocks and bonds.
Some differences between active and passive investing include:
- Passive investing usually involves fewer buy and sell transactions than active investing. In the case of a mutual fund or ETF, fewer transactions generally means lower fund expenses and may result in fewer capital gains being triggered and passed on to the mutual fund or ETF holders. In general
- Passive investing in an index mutual fund or ETF involves the manager doing their best to replicate the performance of the index the fund is tracking. There is no additional analysis or trading involved to try to beat the index performance. Actively managed funds attempt to outperform their benchmark index either on an absolute basis, or in some cases on a risk adjusted basis.
Which is better? – Pros and cons
Both active and passive investing can have a place in your portfolio. In terms of mutual funds and ETFs, this is a very common approach. An investor might use an allocation of passive index funds as the core of their portfolio, adding in active mutual funds or even individual stocks as satellite holdings around their core allocation of index funds. This type of strategy is sometimes referred to as “core and explore.”
That all said, both active and passive investing strategies have their pros and cons. Here is a look at some of the pros and cons.
Passive investing – pros
- Index funds work well in designing and maintaining an asset allocation strategy. Index funds stay true to their asset class by their nature. This makes setting a target asset allocation and rebalancing back to their target allocation over time relatively easy.
- In recent years, many index mutual funds and ETFs have outperformed many of their actively managed peers.
- The nature of passive investing lends itself to lower expenses, lower costs to manage index funds as well as lower trading.
- Passive index funds are generally more tax-efficient than due to this less frequent trading versus an actively managed fund.
Passive investing - cons
- By design, passive index funds are designed to track a market index, not beat it. If you are looking to beat the market, passive index funds are not the vehicle for you.
- Most index funds are market cap weighted. This means that the largest holdings in the fund could have a larger impact on the fund’s performance during a market downturn if these holdings are hit hard.
Active investing - pros
- There is greater upside potential from an actively managed mutual fund or ETF if the manager’s strategy is able to produce results that outperform the fund’s index benchmark. Active managers have a goal of beating the market, not matching the performance of an index.
- The fund’s manager and the analysts working with the manager have a broader pool of investments within the fund’s investment objective to choose from rather than just being limited to the securities that comprise a particular stock or bond index.
- Fund managers can buy or sell at any time depending upon what their analysis tells them, versus waiting until there is a change in the makeup of the underlying index the fund is tracking.
Active investing – cons
- It’s hard to be right regarding which stocks or bonds to buy or sell on a consistent basis. Outperforming the market is hard and this is why so few fund managers and investors are able to beat the market on a consistent basis.
- There is no guarantee of any level of consistent performance with an actively managed fund. With an index fund you will generally at least get performance that is in line with the underlying index.
- Actively managed funds are less transparent than an index fund. Active managers generally do not want their competitors to know their investment strategy, so they only disclose holdings a couple of times during the years in line with regulatory requirements around disclosure.
- Actively managed funds generally have higher expenses. This is due to the higher cost of running the fund in terms of having analysts to choose stocks and bonds to buy and sell. These funds typically trade more frequently than index funds and incur higher transaction costs. These expenses are all passed on to fund shareholders in the form of higher expense ratios that reduce your net return.
- Actively managed funds will often generate more in capital gains distributions to shareholders than a passive index fund. This is because they are trading more frequently which can result in more realized capital gains.
Do active managers outperform passive managers?
The answer is that some active managers do outperform their passively managed peers. This outperformance may be for a short period of time or perhaps longer over the course of a number of years.
It is tough to sustain outperformance no matter how solid the active manager’s investment strategy is. There are a number of reasons for this. If a manager is successful, their fund might attract more assets from investors. If a fund becomes too big it can be tough to put this extra money to work in a way that replicates it’s past performance.
Sometimes an investment strategy will be in sync with the markets at a particular time. As the economic and market landscape changes, the strategy may not outperform as in the past.
What percentage of active managers outperform?
While this percentage will vary over different time periods and for different investment categories, a study by Morningstar showed that only 24% of all active funds outperformed their passive index peer over the ten year period through June of 2020.
In their study, active U.S. large cap funds tended to have the worst success rate against their peers, while actively managed foreign stock, real estate and bond funds tended to perform better when compared to their passive index peers.
How do you tell if a fund is active or passive?
In order to tell if a mutual fund or ETF is actively managed or if it is a passive index fund, you will need to do a little reading. Sometimes it’s fairly obvious from looking at the name of the fund. It may say something like an S&P 500 Index or Total Stock Market Index right in the name.
Other index funds will probably have something about the fund being an index fund in the first few lines of the fund’s description in places like Morningstar or in the fund materials.
Active funds will tend to have higher expense ratios than index funds. Their investment description will also reference their investment process as well. If you still are not sure, give the fund’s customer service number a call.
Both active and passive index funds can have a place in your portfolio. Be sure to understand the investment process for active funds and the index that is being tracked for passive funds. Also understand the risks of each type of fund in putting together your portfolio.