A long standing debate in investing is whether active portfolio management is a better strategy than passive portfolio management. Since many people I talk with are not aware of these concepts, I thought I would offer a short primer on the topic.
Active Management – Focus on Beating the Market
With an actively managed portfolio, a manager tries to generate investment returns that exceed the returns for a given benchmark index — also known as trying to beat the market. How is this done? The manager of such a portfolio selects individual securities to be a part of the investment basket. The active management position is that the various markets have pricing inefficiencies from time to time which create investment opportunities. The selection process is based on criteria and/or judgment of the manager, focusing on specific securities and the timing of trades. Typically, however, higher trading costs and turnover issues place actively managed portfolio costs (which eat into net returns) above passive management,
Proponents of active management believe that by picking the right investments, taking advantage of market trends, and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index. For example, an active manager whose benchmark is the Standard & Poor’s 500 Index (S&P 500) might attempt to earn better-than-market returns by overweighting certain industries or individual securities, allocating more to those sectors than the index does.
A manager might also try to control a portfolio’s overall risk by temporarily increasing the percentage devoted to more conservative investments, such as cash alternatives. However, an actively managed mutual fund’s investment objective will put some limits on its manager’s flexibility; for example, a fund may be required to maintain a certain percentage of its assets in a particular type of security.
Passive Management – Focus on Reducing Costs
On the flip side of this debate is the passive manager. With a passively managed portfolio, the manager attempts to generate investment returns that match the returns for a given benchmark index — sometimes referred to as indexing. The passive manager contends that it is difficult if not impossible to “beat the market” consistently over time. Therefore, the manager doesn’t attempt to pick and choose winners. Rather he or she fills the portfolio with the same securities that are contained in the benchmark index that is focused on an overall sector or asset class.
Because the passive portfolio simply reflects an index, no research is required for securities selection. Also, because trading is relatively infrequent–passively managed portfolios typically buy or sell securities only when the index itself changes–trading costs often are lower. Also, infrequent trading typically generates fewer capital gains distributions, which means relative tax efficiency. Even with these lower costs, however, it is likely the portfolio will have a return slightly lower than the benchmark due to the costs associated with real world trading.
Advocates of passive investing have long argued that the best way to capture overall market returns is to use low-cost market-tracking index investments. This approach is based on the concept of the efficient market, which states that because all investors have access to all the necessary information about a company and its securities, it’s difficult if not impossible to gain an advantage over any other investor. As new information becomes available, market prices adjust in response to reflect a security’s true value. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.
Popular investment choices that use passive management are index mutual funds and exchange-traded funds (ETFs). However, some actively managed ETFs are now being introduced, and index mutual funds and ETFs can be used as part of an active manager’s strategy.
We’ll cover more on this topic in posts over the coming months.
Have questions? Contact Mary. This article is for informational purposes and should not be taken as legal, tax or investment advice.
