Society of Certified Senior Advisors: Active vs. Passive Investing

Active and passive investing are two different strategies for optimizing a portfolio. Wise investors know a little about each.

As political debates heat up around the country, believe it or not there is also an ongoing debate that rages hot in the investment industry. Does active or passive investing produce better results for an investor? Most investors are familiar with the concept of investing in a diverse mix of securities over time and expecting a certain return that is at least reasonably in line with broad market indexes. Passive investing and active investing are the two major methods by which to achieve this goal.

To begin, let’s define passive and active investing.

Passive investing is predicated on the belief that investments will always trade at a value that reflects all available market information with nothing being overvalued (expensive) or undervalued (cheap). Instead of trying to beat the market, passive investment managers own securities in the same proportions as the indexes (such as the S&P 500 or the Dow) they track. This is typically a less expensive way to invest because the investor doesn’t have to research companies, rare changes to the tracking index are automatically mirrored in a portfolio, and overall trading costs and taxes are reduced. Buying and holding (referred to as “buy and hold”) is another form of passive investing.

Active investing is based on the belief that markets are inefficient, so there are opportunities to be exploited, or that investment advisors can uncover information unknown to others that can lead to better returns versus an index. Active managers invest in what they view as the most attractive securities, based on their own investment philosophy and market outlook.

Passive Investing Pros and Cons

Proponents of the buy-and-hold approach often look to Warren Buffett as the model of success. Buffett’s Berkshire Hathaway holding company buys and operates many successful companies. Its stock price has never split because Buffett believes the high price (over $341,000 as of this writing) encourages shareholders to be long-term investors. He has promoted long-term investing for years, once telling shareholders, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

Berkshire stock is made to compound (grow), and the equity has an enviable track record. From a worth of $91 billion in 2005, it is currently valued at $375 billion, for an average yearly compounding rate of 10%. By contrast, the S&P 500 index has seen book value grow from 453 to 914 points over the same time, for a 4.7% growth rate. Add in the average dividend of 2% to the index value (Berkshire doesn’t pay dividends), and you get an average annual rate of 6.7% compounded growth over the same 15-year period.

For most, our largest retirement nest egg accumulates in a 401(k) or some other employer-sponsored plan. The investment style in these accounts tends to be defined as passive, either by design or by sheer neglect. Most of us choose from a predetermined menu of mutual funds during initial enrollment and usually forget about it. Many investors and fund managers also subscribe to this popular style of management.

Passive management is also the investment objective of many exchange traded funds (ETFs). When you buy the Vanguard S&P 500 ETF (symbol VOO), you are buying a basket of all 500 companies in the S&P 500 index. Very little changes within the ETF while you own it. In this case, passive management is used to replicate a specific benchmark in order to match its performance. In general, the truly passive investor believes the future will develop similarly to the past, and market prices are too efficient (not cheap and not expensive) to be exploited by long-term investors.

Active Management Pros and Cons

Active portfolio management is different. This approach does not place unwavering trust in the historical performance of assets. Instead, the active manager periodically adjusts a portfolio in response to changing market conditions, believing desired outcomes can be more consistently achieved through vigilant risk management. In other words, there are times when it makes more sense to be invested in some specific companies, industry sectors or even asset classes because they represent the best opportunity in that moment.

There are many forms of active portfolio management. In their attempt to exploit market inefficiencies, active managers can use a combination of asset allocation and security selection. Asset allocation refers to a portfolio’s exposure to different asset classes, such as equities (stocks), fixed income (bonds), commodities (anything from cattle to precious metals) or cash. Individual security (stock or bond) selection goes one level deeper—using a careful analysis to choose specific securities within an asset class (such as evaluating Apple vs. Microsoft in large-cap tech or a high-grade vs. a low-grade corporate bond). Active portfolio management can also vary based on a manager’s desired holding period. Time horizons can range from several years to only a few minutes. Of course, some strategies will be successful, while others are destined to fail. A certain level of expertise is a requirement of, but does not guarantee, long-term success.

Active management is sometimes characterized as being focused on beating the market and not on long-term investing. That is not always true. While any investor should be satisfied with out-performing their benchmark (an expected rate of return based on how different assets performed at the investor’s risk tolerance), the main objective for some managers is risk management. Market history shows us extended periods of little, or no, market returns. Buy-and-hold can have some shockingly poor outcomes if you are nearing retirement. History shows that poor market returns (as measured by the S&P 500 index) have occurred over periods as long as 20 years. In fact, there are some historic periods where 20-year market returns after inflation averaged less than 1% per year. This is the risk a buy-and-hold approach presents, and that an active management strategy can potentially avert. Managers are able to minimize risk through a variety of strategies. Some of the more common are gradually moving a greater percentage of a portfolio into more stable assets, like bonds, “tilting” assets toward one or more classes, or converting a portion of equity funds into cash reserves on a short-term basis.

Another criticism of passive management is that higher fees erode performance. Although there are differences in the way active and passive asset managers are compensated, the major difference lies in the strategy and philosophy of each approach. The passive or buy-and-hold philosophy believes that over the long haul the growth of their holdings will outperform, or at least keep pace with, the broad market. The active manager takes an approach of managing current risk when determining which equities to buy and sell for their clients. Active managers make changes to the portfolio over time in order to take advantage of opportunities as well as manage risk.

Summing Up

Investing can be as simple as allocating your money to a few low-cost index ETFs, or as complicated as buying and selling an array of investment products. Individual investors should keep it simple if they are managing their own portfolio, unless they have expert knowledge. A good financial planner who is a fiduciary, bound to act in the sole interest of his or her clients, can discuss active strategies from a risk-reward standpoint, including the effect of anticipated cost versus a passive portfolio. What is right for one client is not necessarily a good fit for another. Risk tolerance, timing, years to retirement (or from retirement) and other factors should be discussed before arriving at a decision.