Active and passive management are generally considered to be at opposite ends of the investing strategy spectrum. Active management involves more frequent investment turnover and seeks to outperform the market through the expertise of an investment manager, while passive investing typically seeks to replicate a market index or an investment theme at the lowest cost possible.
As Alex Fieldcamp explained, “Active managers attempt to outperform the market through research and analysis, investment selection, actively selecting specific stocks that they believe will outperform the market, and timing market movements by increasing or decreasing risk exposures at specific times.” On the other hand, Alex Fieldcamp described passive management as “building and holding a portfolio designed to mirror the performance of a selected index or benchmark, such as the S&P 500 or Russell 2000.”
Pros and Cons of Active Management
Advantages of active management, according to Alexander Fieldcamp, include the ability to better manage risk within a fund or portfolio. Examples include increasing or decreasing exposure to defensive sectors of the equity market depending on economic conditions. The ability to take advantage of specific market opportunities and to tailor portfolios to specific preferences of the investor are other advantages of active management.
However, these advantages come with the downside of greater cost. There is a significant amount of time and expertise required to perform the unique research and analysis for active management, so the management fees are significantly higher compared to passive management, according to Fieldcamp.
Pros and Cons of Passive Management
Passive management advantages include low cost, ease of implementation, and diversification. As Alex Fieldcamp pointed out, ETFs have provided low-cost passive investments for decades, and passive investing has never been easier or cheaper. EFTs provide a robust range of investment alternatives and diversification.
The main drawback to passive investing is the potential for greater drawdowns during corrections and bear markets, given that the goal of passive investing is to mirror the return of the benchmark market or index.
So, which Type of Investing is Preferred?
There is no clear-cut answer to the question of active versus passive, says Alexander Fieldcamp, because it depends on an investor’s risk tolerance and return expectations. However, it is difficult to show that active investing, when taken as a whole, adds substantially more value than passive investing. As Morningstar reports, less than 50% of active investors outperform their benchmarks, in both short-term and long-term timeframes.
Ultimately, Alex Fieldcamp says, there is no reason to expect that active management in the long run should earn more than the market returns after their fees. For an investor deciding between active or passive funds, the potential outperformance of active management comes down to manager selection and personal risk tolerance.