As an investor, you have to decide whether to invest on your own (often referred to as a DIY investor) or with help from a financial advisor. Whichever option you select, you’ll also need to decide whether your investment philosophy will be “active” or “passive.”
If you work with a financial advisor, you’ll want to be sure that the approach to investing followed by your advisor aligns with your decision on the active vs. passive investing issue.
Here is information to help you make that critical decision.
What is active investment management?
Active management is an investing style where the investor (or portfolio manager of an actively managed mutual fund) selects investments with the goal of generating returns superior to a benchmark (like the S&P 500 index).
A fundamental belief of active management is that there are market inefficiencies that can be exploited to find undervalued or overvalued stocks. Active investment managers also often believe they can achieve higher returns with less volatility than the benchmark index.
What is passive investment management?
Investors who pursue passive management don’t make changes based on capital market expectations. If a “passive” portfolio manager is responsible for an S&P 500 index fund, the goal will be to replicate the returns of that index.
While the manager will sell stocks when they are no longer part of the index, the perceived value of the securities in the index will not be considered.
Pros of active investment management
The primary goal of active management is the potential for higher returns than the benchmark index. For example, if the benchmark index is the S&P/S ratio 500 index, the goal of an active fund using that index as a benchmark would be to generate higher returns, net of fees, than an index fund that is tracking that index.
Another possible benefit is flexibility. Theoretically, an active investment manager can respond to events likely to impact the market by reducing or increasing risk. A passive investment manager must track the benchmark index and ignore other factors.
Cons of active investment management
The management fees of active managers are generally higher than those charged by index and exchange-traded funds. Investors are paying for increased costs associated with selecting outperforming stocks or trying to predict when to reduce or increase risk in their portfolios.
S&P Dow Jones indices’ reports consistently demonstrate underperformance by actively managed funds compared to passively managed ones, especially over the long term and after accounting for fees and taxes.
Over a 15-year horizon (as of June 30, 2022), more than 70% of actively managed funds failed to outperform their comparison index in 38 out of 39 categories.
Poor performance in bear markets
Given the flexibility of active fund managers to react to changing market conditions, it seems logical to assume they would outperform their passive counterparts in bear markets. This assumption has been described as a “durable myth.”
According to one analysis, most active managers do not consistently outperform in bear markets. In some bear markets, more than 50% of active managers outperformed, but in others, they didn’t.
Only 25% of active managers who outperformed in one bear market were able to replicate their outperformance in the next one.
Lack of persistence
The data does not support choosing actively managed funds based on a history of outperformance.
Active management outperformance typically lasts for only a short period. There’s no reliable way to determine which actively managed fund will outperform prospectively.
One study found that “over a five-year horizon, it was statistically near impossible to find consistent outperformance.”
Pros of passive investment management
The management fees of passive funds are typically lower than actively managed funds. Lower fees mean you keep more of your returns.
Because passive funds typically track broad indexes, your holdings should be well-diversified.
Passive funds usually have lower turnover than actively managed funds, which could reduce trading costs and tax liability.
Cons of passive investment management
Passive fund managers hold stocks in the index in good and bad markets. They don’t have the flexibility to react to events that impact the market.
The trend toward passive investing
In recent years, investors have clearly preferred passive over actively managed funds.
According to the Investment Company Institute, the total net assets invested in mutual funds was $9.9 trillion in 2011. Of that amount, only 20% was invested in index and exchange-traded funds. In 2021, total net assets increased to $29.3 trillion, while the share of index and exchange-traded funds grew to 43%.
Active vs. Passive Investment Management: Which one is for you?
Investors should carefully consider the pros and cons of passive and active investing. You can combine index and actively managed funds in your portfolio if you believe that’s the best option.
Seeking the assistance of a credible fiduciary advisor and wealth manager is also a way to ensure you’re on the right track to growing your assets accordingly. Check out Allied Integrated Wealth and schedule an online consultation today to get started!