Now more than ever investors have an overwhelming amount of information and access to investment markets. Never mind decisions about investing in cryptocurrency, fine works of art, or direct real estate investments, one of the core investment allocation decisions investors are faced with is active versus passive investment funds. Both active and passive strategies seek to achieve the same thing- meet the goals of your investment strategy by capturing the returns in the chosen asset class. However, understanding each portfolio management strategy is essential to helping you and your financial professional determine the appropriate strategy for your situation.
Active management, by definition, is performed by asset managers who buy and sell securities to outperform benchmark indexes such as the S&P 500. Active management involves researching market trends, economic data, company financials, and other information to determine if they should buy, hold or sell the asset for the portfolio.
Using an active management style, asset managers aim to leverage their expertise in analysis like predicting the future growth of a company based on economic cycles or confidence in the executive leadership team to provide alpha (excess return above the passive index). Many believe this outperformance is easier achieved in asset classes that include smaller capitalization companies (valued less than $2 billion) or companies domiciled in Emerging Market countries where information about the company is less known to the public. Another impactful active management tool is thoughtfully placing proxy votes in the best interest of investors instead of the status quo, like opposing mergers or voting against large and unwarranted executive compensation packages. There are pros and cons to active management:
- The money manager is continuously researching market trends and company changes to make buy-sell decisions.
- The money manager can make more researched versus emotional based buy-sell decisions that individual investors often struggle with.
- Investors may outperform the market.
- Investors may minimize losses during a down market.
- Actively managed funds charge fees that deduct from returns, resulting in a lower overall return.
- Management fees on active funds are usually higher than passively managed funds.
- Actively managed assets may include complex investments or investment strategies that are complicated for investors to understand.
- Actively managed strategies may take on more significant risk to achieve higher returns.
Active management enables asset managers to filter for qualities in a company that aims to follow their portfolio's investment strategy and purchase or liquidate shares if the company fails to address their expectations. Changing the portfolio composition ahead of impacts to the stock price these failures could cause is alpha that would otherwise be lost. For this reason, investors and their financial professionals must analyze fees to ensure the asset manager outperforms net of fees in various time periods, particularly over the long term (3 years+).
Passive management invests the fund in companies in the same proportion they are represented in a selected index, like the S&P 500. There is no intention to outperform the index, only to gain exposure to the intended area of the market the index would expose an investor to.
Often financial professionals will use passively managed funds for part of investor portfolios where markets are highly efficient, like large cap US stocks. Any impactful company changes usually makes news headlines, thus making it difficult for the stock price to escape the impact of investor behavior resulting from that news. Just like active management, passive asset management has both pros and cons:
- Fees assessed on passive managed funds are often lower than actively managed funds, thus making it harder for an active fund to outperform net of fees.
- Index funds are often easier for investors to understand.
- Some asset classes don't easily enable passive asset management.
- While passive asset management produces positive returns mirroring an index, equally declining returns may result.
Index investing proponents claim the performance net of fees does not warrant investment in active funds, yet all of these US equity-focused active mutual funds by American Funds have outperformed an investment in the S&P500 since it was launched in 1976.
Click here for more information about American Funds.
Financial professionals generally use both asset management styles, which enables them to build their portfolios through using third-party asset managers that are either active or passive managers. Having the ability to use both active and passive management styles helps financial professionals ensure they are meeting the needs of their clients by selecting the strategy that provides clients the best exposure to the asset class.
So which asset management strategy is best for your situation? Together, you and your investment professional can determine a strategy that works for you which may involve one or a combination of asset management strategies.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.