So you’ve decided to engage in one of the most divisive arguments in investment philosophy – actively versus passively-run strategies. You’ve probably heard these terms thrown around, and you may have even used them yourself. But are you aware what it means to invest in an active or passive investment? If not, you have come to the right place. We’re going to break down these strategies, discuss pros and cons, and provide you the framework to make an educated decision on investment philosophy.
Defining Active vs Passive Strategies
Active money managers (those individuals who run mutual fund investment strategies) have long used proprietary evaluation systems designed to help them assess the value and opportunity of an investment. These money managers look at the various qualitative and quantitative factors which affect the intrinsic value of an investment and then make the decision to buy, sell or hold an investment based on their analysis.
On the other hand, passive money managers don’t have to evaluate Investment A vs. Investment B as their investment strategy is typically guided by the benchmark index that fund tracks. Fund managers of passive investments believe that growth in value is a long-term play, thus utilizing a buy and hold investment strategy. In most instances, you will be familiar with this strategy in the context of an index fund, where a money manager just “mirrors” their own investment with those of an index, defined as a basket of investments that are similar to one another. It is important to note that not all passively managed investments are index funds, but for the purposes of this article, we will assume the passively managed investment option is an index fund and we will use both terms interchangeably.
Did you know that every investment has a benchmark index it’s compared to? If I told you that Investment A returned 15% over the course of a year, your initial reaction may be that the investment performed very well. On the other hand, what would be your reaction if I told you that Investment A returned 15% annually while everyone else returned 18%? By comparing the investment to its appropriate benchmark, you now have a clearer understanding of the investment’s performance and potentially what type of investment it is. Actively run investments share a common goal: outperform their respective benchmarks. Passively run investments also share a common goal: mirror/track the comparable benchmark’s investments on a daily basis, and generally at a low-cost.
Pros and Cons of Active and Passive Strategies
So which strategy is better? Well, it’s hard to say. Historic data shows that it is incredibly difficult to consistently outperform the market. Nevertheless, investors try each year, investing billions of dollars in their own attempt to “beat the market.”
Both active and passive strategies have their pros and cons. An actively managed investment is generally understood to be more flexible in nature. A team of money managers are able to react to short-term market fluctuations and business cycles, unlike passive strategies that are tied to their benchmark. If outperforming the market through a publicly available investment is your goal, an actively managed strategy is virtually the only way of doing it. But remember, that’s easier said than done. It is not uncommon that active money managers make the wrong bet and end up losing money, or at least not performing as well as their passive counterparts or other active peers. The analysis techniques used by money managers is often proprietary and is not guaranteed to always be accurate.
Further, actively managed investments are decidedly more expensive. In 2019, Morningstar found that the average expense ratio for an actively managed equity investment was 0.66%, in comparison to its passively managed counterparts at an average of 0.13%. Money managers must be compensated for their effort and expertise in actively managing an investment, and that compensation comes in the form of higher expense ratios to investors. Passively managed investments, along with being less expensive, are also typically more transparent because of their necessity to mirror a public benchmark. Unlike actively managed investments, these funds are not flexible and are not capable of reacting to market fluctuations. A passive investor should not expect excess returns beyond the investment’s benchmark.
So what should you do?
Each individual’s investment philosophy is different. Actively managed investments are often more nimble and able to adjust with market fluctuations. With that comes additional risk and cost. A passively managed investment, on the other hand, is less flexible, but also lower cost and at lower risk of a money manager making an inherently bad bet on the market.
Part of being an informed and educated investor is understanding the risks and rewards of each style of investing. An educated investor understands their financial picture holistically, and how either of these strategies best helps them reach their financial goals. If you’re having a tough time matching your investment strategy to your investment goals and risk appetite, reach out to Forest Capital Management for a consultation.
General disclaimer: This information discusses general market activity, industry or sector trends, or other broad-based economic, market, or political conditions and should not be construed as research or investment advice. Views and opinions expressed are for informational purposes only, are current as of the date of this publication, and may be subject to change.