Are active investment strategies really superior to passive?

Active and passive strategies are two approaches to investing that can result in two very different (or very similar!) outcomes. Investors have long debated which approach is superior, when, in fact, there may not be a clear-cut winner. Let’s review the key differences between the two.

Active investing seeks to beat the market

Every investment category has a benchmark or point of reference. For example, a common benchmark for US stocks is the S&P 500 index. Active investing is any investment strategy where the portfolio manager attempts to “beat the market” (that is, to have that strategy outperform its benchmark) by making “active” decisions. These active decisions could include the manager’s choosing specific securities, sectors, asset classes, or regions for the strategy (rather than investing in all securities that make up a certain benchmark).

Because of the additional resources needed to manage active portfolios, it’s typical for funds that employ an active strategy to have higher expense ratios than passive strategies.

Passive investing says, “If you can't beat it, track it”

Passive investing is any investment strategy that seeks to track the performance of its benchmark. This approach has become more popular in recent decades, with the rise of index funds and exchange-traded funds (ETFs).

Unlike with active investing, the portfolio manager of a passive strategy does not make any bets regarding which stocks or sectors to buy or sell. Instead, the portfolio manager simply constructs a portfolio that adheres as closely to the benchmark as possible. If the portfolio manager does a good job, investors will experience returns that track very closely to the index’s performance (minus expenses, which are typically considerably lower than with active strategies).

Consistently beating the market is nearly impossible

The investment community has long debated whether active portfolio managers can consistently beat the markets. One argument in favor of passive investing is that active managers typically don’t beat their benchmarks on a consistent basis after fees are taken into account. This is one reason why, after the 2008 recession, more and more investors started choosing to invest their money in passive strategies. In fact, as of December 2017, a little more than one-third of all assets in the U.S. we’re in passive funds, up from about one-fifth a decade ago.*

Active investing may be better suited to navigate volatile markets

Critics of passive investment strategies note that they may be less effective during more volatile markets, when a skilled active manager can theoretically select attractive investments while avoiding problematic ones and attempt to limit the strategy’s downside or risk of losing value. Passive strategies aren’t able to make such distinctions and must own all securities that make up the underlying benchmark. They are also generally exposed to the movements of the market.

It’s important to note that the evaluation of passive versus active strategies differs based on investment categories. For larger, more mature markets such as large cap US stocks, there may be less opportunity for managers to pick “winners” and “losers.” This would suggest that a passive approach could be more beneficial in this category. For less "efficient" markets (where an asset’s market price doesn’t always accurately reflect its true value, indicating more potential for gains), such as small cap or emerging market stocks, there may be more opportunity for active managers to make selections that help the fund outperform its benchmark, possibly making active strategies more attractive.

The debate wages on …

As the debate over active or passive wages on, investors need to be aware that there are pros and cons to both strategies. Ultimately, active and passive investments are both tools that can be valuable in investor portfolios and financial plans.

*Bloomberg, ICI, December 2017