Active vs passive investment management: What to consider

Content Type: Article

Both investment styles have their strengths. Here are the differences—and how to leverage both for your business.

One objective of investing is to maximize returns while minimizing risks. But there are two distinctly different approaches to follow in pursuit of that goal: active and passive investment management.

Active investment management means a fund manager is in charge. The manager will seek to outperform a chosen benchmark, such as the Standard & Poor’s 500 (S&P 500) index, by researching potential investments, then buying and selling holdings based on the fund’s specific mandate or goals. The alternative is a passive approach. In this context, passive refers to the creation of a mutual fund or exchange-traded fund (ETF) that is designed to mirror a stock market index, such as the Nasdaq Composite.

“Both options have their pros and cons. And they both have the ability to serve clients and meet their goals,” says Marcus Hopkins, an institutional portfolio manager at Regions Bank.

Before you decide how these options can work with your organization’s existing investment strategy, consider the strengths of each.

Assessing the trade-offs

Active investment management is a hands-on approach that requires more time, effort and skill than passive investing. As active fund managers seek to outperform the market, they must thoroughly research the investments available within the fund’s targeted asset classes. It’s a labor-intensive process, requiring a deep understanding of—and research into—financial markets, specific industries and individual companies. Active fund managers spend a lot of time gathering pertinent information and buying and selling securities in pursuit of higher returns. They are paid for the time and effort involved, which can result in higher investment management fees.

The rewards of active investing may also be higher. When the fund manager makes the right selections, the fund can generate higher returns than its passive counterparts. For example, an adept manager could steer clear of a troubled part of the market or an overvalued stock that faces heightened competition or new regulatory concerns. However, there is also the risk of an active manager being wrong and trailing the returns of a benchmark. As with all investments, you should be aware of—and comfortable with—the amount of risk.

Passive investing simply follows a selected index. It doesn’t require as much management, so the fees tend to be lower than those of an actively managed fund. Because the passive fund follows an index, the investment returns will generally be similar to the performance of the index the fund follows (before fees).

When it comes to passive funds, there is a lower turnover of portfolio holdings and, often, greater tax efficiency. Since holdings are less likely to change as frequently, you may have fewer capital gains payouts to contend with. Your organization’s tax professionals can advise you on the tax repercussions of investments.

Building an approach that works for you

Companies looking for the best of both worlds may be able to combine the strategies. By being selective and trying to use each method in the optimal circumstances, investors may benefit from the strengths of each, while limiting unintended consequences, such as paying for active management while only receiving passive (or lower) returns. To be effective with this hybrid approach, understand when it makes sense to use each strategy and how active and passive investing may complement one another. Here are some tips to help you determine which method might be appropriate.

Consider your investment

Generally, investment niches that are followed by fewer analysts, such as U.S. small-cap stocks and emerging market stocks and bonds, have less research available about them. That creates additional opportunities for astute or well-informed fund managers to have an edge. Therefore, those types of holdings are prime candidates for active management.

In contrast, U.S. large-cap stocks are very closely covered, providing far fewer opportunities for active fund managers to glean insights that can lead to outperforming a benchmark.
Assess market volatility

There are certain times when active management might offer more of an advantage. Generally, calm markets offer less opportunity for the research, knowledge and skills of a strong active manager to be harnessed. Conversely, volatility creates a fertile environment to apply discerning or insightful research into potential winners and losers.

“Looking historically, active management has tended to perform better in environments that are more volatile,” says Hopkins. “That’s because volatility creates opportunities for managers to be able to avoid parts of the market that may be riskier or perhaps are getting overheated.”
Acknowledge your investing style

There are certain people who might be better suited to either active or passive investing. For example, investors who have less investing knowledge, or are less inclined to follow the market closely or monitor an active manager’s relative performance, might be better suited to passive investing.

Investors who tend to enjoy tracking market (and fund manager comparative) performance might be ideal candidates for an active investment approach. Depending on the resources and staffing of your organization, you might want to consider how the time researching might impact your budget.

The value of patience and a long-term view

Whether one follows an active, passive or hybrid approach, the most successful investors tend to maintain a healthy perspective for long-term market and fund performance. A combination of active and passive investment management may help you meet your overall objectives.

“When searching for active management, look for a team that has continuity. A team that has proven over multiple market cycles that their strategy can add value,” Hopkins says. “You can add diversification to the overall portfolio with an active strategy that complements a passive strategy.”