Active Or Passive Investment Management: The Pros And Cons

An ongoing argument in many investment circles is whether to take an active approach where you pick and choose which securities to buy and sell based on a fundamental, technical and other types of research, or whether you should take a passive approach where you stick with an Index and follow that passively, most often through an exchange traded fund (ETF) or an Indexed Mutual Fund.

There are some very compelling arguments for each management type, which we look at here. The bottom line, however, is that both require active monitoring but often for different reasons.

Active Management

In an actively managed investment portfolio, the investor will pick and choose which funds in which to invest. These portfolios clearly involve a lot more work for the investor given the amount of market and specific security research that will go into deciding which securities to hold, but the test of success will often get measured against an index, such as the S&P 500. For this reason, active portfolio managers will often be sure to incorporate many of the index’s bigger names in order to provide several key, core holdings.

The management of actively managed portfolios is intensive as well and it requires considerable discipline. Since the success of any portfolio is often attributed to one’s asset mix, making sure higher growth assets are trimmed at times when it might “feel” better to let them ride is not an easy decision. And knowing what to do with the excess capital once those positions have been trimmed is not so easy, either. With active management, you are a lot more active.

Passive Management

Although passive management implies that an investor puts money into and index fund and leaves the portfolio alone for thirty years or however long one decides, this is not the case. For passive investors, there will always the matter of rebalancing their overall portfolio so that they are not overexposed to one asset class or another. However, the bigger risk is investing in the wrong index. So while passive investment management means eliminating the need to pick individual securities, it does not let the investor completely off the hook. Given the sheer number of equity indexes out there, figuring out which one works best and at which time (remember, they are still equities) is the tough decision.

In other words, the analysis and decision making remains, even with index investors, but the scope and type of analysis is quite different. In some ways, it could be easier, but the investor will likely take a more macro view of which segment or index is likely to perform well.

For investors that really want to be passive, sticking with a broad index, like the S&P 500 index, can certainly make sense. However, with the returns such a broad index has returned compared to others, it may make more sense to get into an actively managed mutual fund instead, where security selection is looked after and where many have returned much better than the index.

Summary

Deciding whether to be an active or passive investor is not an easy decision. Both require a fair degree of discipline and at least some time to monitor the progress and performance of the portfolio. Working with a professional planner is often the best solution in both instances.A�