There has been an on-going debate for years between active and passive investment management. Typically, everything you read will defend one side over the other. Of course, this polarizing approach stirs the pot and makes for great articles. The truth is none of these articles address an individual investor’s unique situation. I’m not in the business of telling people that there is only one way to be successful in investing because that is simply not the case. Before I dive into what REALLY matters in this debate, I’d like to provide a brief overview of both strategies.
An investment strategy where managers “actively” construct a portfolio that is different than the comparable investment index/market with a specific goal in mind. Most often, the goal is to “beat” the index/market. This goal can be achieved by a combination of both increasing positive returns or decreasing negative returns. Due to the active nature of these funds, the underlying fees are typically higher than those in the passive category of investing. Such fees can widely vary from one fund family to the other based on many factors.
Important Warning: Don’t be tricked into thinking that a higher cost fund will get you better overall returns! Many quality sources such as the Morningstar Active/Passive Barometer report have discovered that the greatest factor in the performance of actively managed funds are the fees. Funds with lower fees typically outperform and have greater success than funds with higher relative fees. (Read more about fees in our article, Breakdown of Investment Management Fees)
An investment strategy that simply seeks to track the underlying index/market. They are not trying to outperform but instead take on the same risk and return of the market. Due to the passive nature of this strategy, the fees tend to be lower than actively managed funds. It is important to note that not all passively managed funds are the same. Some funds weight the underlying investments by overall market capitalization (size) and others may weight the investments equally. For instance, there are companies like Apple or Google that are worth around $1 Trillion in size and others worth a few billion. Funds that weight investments equally may have the same percentage of the overall portfolio in each company, no matter their total size.
Keeping in mind the meaning of active and passive management, let’s dive into what really matters in this debate.
To put it simply, there are efficient markets and there are less-efficient markets. An example of an efficient market would be the U.S. Large-Capitalization market. This is a very transparent market, with most of the pertinent information made readily available to the public. Everyone has access to information on all the big name companies in the U.S., therefore there is very little opportunity to pick individual stocks that will outperform this group as a whole. An example of a less-efficient market could be the Emerging Markets. This market is made up of countries that are in the process of becoming more advanced and developed through growth and industrialization (i.e. China, India, Brazil, etc.). Because they aren’t at the United State’s level of industrialization and accounting, there is information that may not be easily accessible to the public and require in-depth research. This type of market provides greater opportunity for active managers to select companies who may outperform/underperform the group as a whole.
Takeaway: Active management can provide more value to investors by investing within markets that have less-efficient access to information (i.e. Emerging Markets, Small-Capitalization, etc.)
For the sake of simplicity we are going to talk about two account types here: Tax-efficient and Tax-inefficient. (Yes, the investment industry loves the word efficient). An example of a tax-inefficient account is your typical savings, checking, or taxable investment account as these accounts are susceptible to taxation on an annual basis. Any interest, income, or capital gains received from these accounts will be included as a line item on your 1099 Tax Form. In other words, your money grows inefficiently due to the annual taxation that occurs on the growth of this money. Examples of tax-efficient accounts include your traditional IRA and 401(k), Roth IRA and 401(k), other retirement plans, and a Health Savings Account (HSA) to name a few. Once the money is inside these accounts, it will not be included on your annual tax return and will grow tax-free. This allows your money to grow more efficiently as it is not nibbled away at each year by Uncle Sam. Yes, there are tax consequences potentially for putting money in/out of these accounts, but that’s for a future article.
Now you may be wondering how these account-types relate to active vs passive management? It comes down to how each are managed. With actively managed funds, there are typically more investment trades being facilitated than a passively managed buy-hold fund. These trades create short and long-term capital gains that are transferred to individual investors and can eat away at overall investment returns.
Takeaway: If using actively managed funds, it is best to hold them inside the tax-efficient (i.e. your IRA’s, 401(k)’s, etc.) accounts so that you can avoid paying taxes on the capital gains.
Articles centered around active vs passive investment management simply do not address the individuals specific situation. It’s like having a dietician prescribing a meal plan without asking any questions about the lifestyle, potential allergies, or bodytype of the individual. These writers don’t know you. Here are some things you may consider:
Takeaway: Over the long-term it may make sense to use passive investments, but if you are managing risk in the short-term (i.e. for specific goals) then it makes sense to incorporate active funds within the inefficient markets.
If you follow the news and the results of the market every day, you may be better off investing through a passive strategy because your investments will track the market and you won’t be thrown off guard. This type of person doesn’t typically do well with an actively managed portfolio because they’ll keep questioning why the market is up and their investments are down, or vice-versa.
Takeaway: There are many personal behavioral factors to keep in mind, all of which may lead you to favor one strategy over the other, or perhaps a blend of both.
The opportunity to reduce the ups and downs in the investment portfolio are a big advantage to active management and have the potential to help investors who have a hard time stomaching the risks that come along with stocks. But this can come at a higher cost than passively managed funds. While there are advantages and disadvantages of both strategies, remember that any well-thought strategy is going to be better than no strategy. It’s important to note personal factors (behavioral and goal-based), the market/index being invested in as part of a diversified portfolio, as well as the type of account that is being invested in. Because of this, you can’t expect the articles available on the internet today to hit all of these factors and prescribe the perfect investment mix for you. This can only be done through a comprehensive and holistic approach that takes the time to understand you and your goals.