The Pros and Cons of Active and Passive Investments
The differences between passive and active management start with an investment index, or benchmark, such as the S&P 500.
The manager of a passive mutual fund or exchange traded fund (ETF) will seek to achieve the return of a particular index, before expenses – nothing more, nothing less. Typically, passive funds own most of the same securities, and in the same weightings, as their respective indices. Passive fund managers make no active decisions, potentially resulting in less trading – which reduces fund expenses as well as potential taxable distributions to shareholders. The performance of a passive fund should mirror the index it’s tracking, which means that the fund will share both the ups and the downs of the index.
This type of simplicity means that many investors feel more comfortable with passive funds as they know what they’re getting – an investment that tries to follow an index. However, a risk of passive investing is concentration. Although markets contain a wide range of companies, they are concentrated towards the very largest. In some cases indices are over-exposed to one or a small number of stocks or sectors that have a large impact on performance. For example, in the 1990s, technology and telecoms stocks became a large part of the FTSE 100; index funds benefited from their growth until their subsequent spectacular decline; financials then became dominant; and then mining shares featured heavily.
In contrast, an active manager will seek to outperform an index by achieving higher returns or taking lower risk, or by combining these two techniques. Because active fund managers choose investments, they have the potential to outperform the market on the upside and limit losses when the market declines, relative to the index. They seek to do this by using their knowledge and skill to analyse the market (hence the higher fees). Then they buy shares (equities) which they believe are presently undervalued, and so have potential to increase in price – or pay increased dividends – over time. This process is known as stock-picking. Managers can also adjust their portfolios to minimise potential losses. However, there is no guarantee that actively managed funds will outperform the index.
Pros of Passive Investments
•Likely to perform close to index
•Generally lower fees
•Typically more tax-efficient
•Simplicity: investors know what they are getting
Cons of Passive Investments
•Unlikely to outperform index
•Participate in all of index downside
•Buy/sell decisions based on index, not research
Pros of Active Investments
•Opportunity to outperform index
•Potential for limiting the downside
•Buy/sell decisions based on research
Cons of Active Investments
•Potential to underperform index
•Generally higher fees
•Typically less tax-efficient