Investors have debated seemingly forever the merits of active vs. passive management. Passive investing aims to duplicate the movements of a major index, like the Dow Jones Industrial Average or, more likely, the S&P 500 stock index or sectors of an index or the European index or a composite of emerging markets indices. Active management attempts to improve on the performance of one or another of these indices. Active approaches can emphasize stock selection, timing market swings, rotating through sectors, or any one of hundreds of other techniques that aim to “outperform the benchmark index,” as the professionals say. A nearby box outlines the pros and cons of the two approaches.
Despite the endless argument, you must decide for yourself which approach best suits your objectives, inclinations, temperament, and tolerance for risk. Many investors mix the two approaches, using one for part of their portfolio and another elsewhere. (Full disclosure: This is the approach I use.) For instance, you might use an S&P 500 index for the large capitalization U.S. stock holdings in your portfolio but use a more active approach for the small capitalization part, where specialized knowledge might have a bigger payoff than with large, well-known companies. The same sort of tradeoff might appeal in the divide between developed markets, where information is plentiful and widely disseminated, and emerging markets, where information and insights are harder to gather.
Once you decide, the financial community offers a variety of ways to proceed. Here are three primary alternatives:
- You can buy individual securities and build a portfolio for yourself. Unless you have immense assets, any such effort will by nature have an active component. Few people have the resources to run a passive portfolio for themselves, which would involve buying every security in an index in proportion to its weight in the index or employing elaborate, computer-based algorithms that can otherwise construct an index-tracking portfolio.
- You can hire professional help dedicated to you: This route can be very expensive, whether you want a passive or an active approach. You could only justify the expense if you have immense wealth and very particular needs as well.
- You can use mutual funds and ETFs: Mutual fund companies, both load and no-load varieties (as described in this earlier post) offer a wide array of active and passive portfolio strategies. Should you want a passive approach, load funds become pointless, since the only justification for the extra fee is superior performance. Many no-load mutual funds offer a variety of passive portfolios at remarkably low fees. Since brokers have a hard time buying no-load mutual funds for their clients, you would have to approach these mutual funds directly to channel your portfolio in that direction. Alternatively, many ETFs offer passive approaches that your broker would happily buy on your behalf.
Passive vs. Active
§ They almost always have lower fees and lower trading costs as well.
§ You always know how well your investments are doing.
§ Most active managers fail to beat the indices. In the past 15 years, some 90 percent of active managers have actually lost to their benchmarks. In other time periods more have done better, but seldom do more than 50 percent beat their benchmark.
§ Passive management offers reliability. They track the index at all times and run none of the risk involved with losing key staff and so suffering performance setbacks.
§ Some active managers do outperform their benchmarks.
§ Active outperformance tends to do best relatively in down markets, which can have a special importance to many investors.
§ Active management, whether you manage for yourself or hire professionals, can offer a greater sense of involvement.
§ Many active managers claim that there really is no such thing as a passive portfolio, since the indices they track are themselves something or an arbitrary assemblage of securities, though the index makers argue that they are representative of the broader market.