When investors and wealth managers talk about active vs. passive investing, the topic can quickly turn into a heated argument because they tend to strongly prefer one strategy over the other.
As the name suggests, active investing is a hands-on method that needs someone to act as a portfolio manager. Active money management aims to beat the average returns of the stock market and make the most of short-term price changes.
It takes a much more in-depth analysis and a lot of experience to know when to buy or sell a stock, bond, or other asset. Most of the time, a portfolio manager is in charge of a group of analysts. These analysts look at both qualitative and quantitative factors and then look into their crystal balls to try to figure out where and when the price will change.
Active managed funds did not outperform the passive ones
The active investing requires trust that the person in charge of the portfolio will know when to buy and when to sell. Active investment management works best when you are right more often than you are wrong.
Managers of active funds have made a name for themselves by helping investors make smart decisions in volatile markets. A new report says that between June 2021 and June 2022, only 40% of the almost 3,000 active funds in the US made more money than the average passive fund.
Morningstar, a financial company based in Chicago, said that 60% of active funds did not last or do better than average passive funds over the 12 months ending in June 2022.
On the other hand, active bond managers had an even worse year. Only 29% of them did better than their average passive fund peers.
The passive approach
If you are a passive investor, on the other hand, you are in it for the long haul. The fact that passive investors don’t buy and sell as much in their portfolios makes this a very cheap way to invest. The strategy needs a “buy and hold” way of thinking. This means avoiding the urge to react to or guess what the stock market will do next.
Buying an index fund that tracks one of the major indices like the S&P 500 or Dow Jones Industrial Average is the best example of a passive strategy (DJIA). When these indices change the stocks that make up the index, the index funds that follow them do the same. They sell the stock that is leaving the index and buy the stock that is joining it.
This is why it’s such a big deal when a company gets big enough to be included in one of the major indices: it guarantees that the stock will become a core holding in thousands of major funds.
When you own small parts of thousands of stocks, your returns come from taking part in the rise of corporate profits over time through the stock market as a whole. Successful passive investors keep their eyes on the big picture and don’t worry about short-term losses, even if they are big.
Active vs. passive investing: pros and cons
In the following, we will summarize some of the most important advantages and disadvantages of the active and passive way of investing.
Active investing pros
The benefits of active investing would be the following:
Flexibility
Active managers don’t have to stick to a certain index. They can buy the stocks they think are “diamonds in the rough.”
Hedging
Active managers can also reduce their risks by using short sales or put options, and they can get out of certain stocks or sectors when the risks are too high. Passive managers have to hold on to the stocks in the index they are following, no matter how well they are doing.
Tax management
Even though this strategy could cause a capital gains tax, advisors can make tax management plans for each investor, such as selling investments that are losing money to pay the taxes on investments that are making a lot of money.
Active investing cons
But these things are wrong with active strategies:
Costs a lot
The average expense ratio for an actively managed equity fund is 0.68%, while the average expense ratio for a passively managed equity fund is only 0.06%.
Fees are higher because all of the buying and selling leads to transaction costs, and you also have to pay the salaries of the analysts who do research on which stocks to buy. If you invest for decades, all those fees can kill your returns.
Taking a risk
Active managers are free to buy any investment they think will bring high returns. This is great when the analysts are right but terrible when they are wrong.
Passive investing pros
A good outlook
Passive investing strategies are based on the idea that investors can count on the stock market going up over time. A portfolio will grow along with the market if it looks like the market.
Stable gains
Morningstar’s active/passive barometer says that over the long term, passive funds do better than active ones. Only 25% of active funds beat passive funds over the past 10 years.
Low prices
Transaction costs are low with a passive strategy because it is slow and steady and there aren’t many trades. Management fees for funds are unavoidable, but most ETFs, which are the preferred vehicle for passive investors, keep fees well below 1%.
Diversified holdings
Investors can also diversify their portfolios in a quick and cheap way with passive strategies. This is because index funds hold a wide range of securities from their target benchmarks, which spreads risk broader.
Less risk
Diversification almost always means less risk because it is what it is. Investors can also diversify their holdings even more within sectors and asset classes by using more targeted index funds. This depends on which funds they choose.
Passive investing cons
Even though passive investing has a lot of pros, it also has some cons.
No flexibility
Even if the managers of an index fund think that the performance of their benchmark will go down, they usually can’t do things like reduce the number of shares they own or buy other securities to protect their portfolio.
Fewer windfalls
Since passive funds are made to match the market, investors aren’t likely to get the big wins that can sometimes come from actively managed funds. In other words, you can’t catch that stock star on the rise. Even if a fund did this, the returns might not be as high because of the other investments in the portfolio.
Less pain, less gain
In the long run, buying and holding can be a good way to make money (at least a decade or two). You can handle the changes in the market. But making the risks the same also makes the rewards the same. Most of the time, active investing gives better results and bigger gains over shorter periods of time.
Active or passive: which one to choose?
Choosing between active and passive investing can also depend on what kind of investments a person makes.
Most of the time, passive management works best for well-known, easily traded assets like stocks in large U.S. companies. This is because so much is known about these companies that active managers are unlikely to learn anything new. Active management for these things is almost never something you should pay for.
But an active manager can find diamonds in the rough in niche markets like emerging markets and small company stocks, where assets are less liquid and fewer people are watching.
It’s a complicated topic, especially for wealthy investors with access to active hedge funds, private equity funds, and other alternatives.
Active investing and passive investing don’t have to be opposites, and a mix of the two could work well for many investors.
Investors who have both active and passive holdings can use their active portfolios to protect their passive portfolios from downturns. A combination approach can also give an investor peace of mind, knowing that their passive, long-term strategy (like their retirement funds) is on autopilot, while their active, short-term strategy (like a taxable brokerage account) lets them explore trends without putting their long-term goals at risk.
