WHAT are active and passive investing?
Active investing is when a manager actively buys and sells securities in a portfolio, usually based on some type of analysis, mathematical
rule, or change in price. The goal of active investing can vary, but it is often an attempt to generate higher overall returns.
Passive investing is when a manager buys and holds the same investments that make up an index, like the S&P 500. While the manager may periodically rebalance, there is otherwise no trading or active intervention. The goal is to passively match the performance of the underlying index, and nothing more.
HOW do these investing styles work?
Active managers use a number of decision inputs. Some focus on company fundamentals, poring through balance sheets and income statements. They believe they are able to spot things others won’t, and then use these insights to choose superior investments. Others rely on real-time price movement, and use software to algorithmically buy and sell.
Passive managers require significantly less involvement. Because they are mimicking an existing index, they don’t need to spend large sums on research or expensive technology. Likewise, trading costs are less because portfolio turnover is much lower. Not surprisingly, the overall fees associated with passive management tend to be significantly less than those inherent in active strategies.
WHY is this concept important?
The argument over which style is “best” has been raging for decades. There are pros and cons for each, but when it comes to
performance, there is a clear winner.
Over long periods, active managers simply do not keep up with markets. This has been proven in study after study, and is tracked by a number of publications. This scorecard by S&P Dow Jones showed that more than 95% of all large cap funds underperformed the S&P 500 in the 20 years ending June 30, 2022.
In most cases, investors are better off with a passive approach. Marketing hype around brilliant managers or flashy investment styles is usually just that – hype.
WHO are active and passive investing for?
Passive investing is a proven strategy for building long-term wealth. It is broadly appropriate for investors with long time horizons and a desire for growth. That does not mean it comes with no risk. Passive strategies can and do lose money in the short-run, just as indexes like the S&P 500 or NASDAQ decline in certain years. For that reason, investors must also have the necessary risk tolerance.
Active investing has more limited applicability, but it can make sense in some use cases where performance is not the primary goal. For example, an investor looking for a
non-performance outcome such as tax mitigation, liability matching, or cross-border currency management, may be well-served through an active strategy. Most anyone else is better served through a passive strategy.