You invest your hard-earned money. Your hard-earned money is invested. Both of these sentences do the job of getting the point across, but they differ in that the former sentence is in the active voice, while the latter is in the passive voice. There is a time and place for each style of speech.
The same holds true for styles of investing. Let’s take a closer look at the difference between active and passive investment strategies.
In an actively managed investment portfolio a manager or team of managers makes informed decisions about how to invest the portfolio’s assets. Actively managed pooled funds have existed for well over a hundred years, but really began as we now know them following the Investment Company Act of 1940.
A passively managed fund closely follows a market index. The managers tend to be far less proactive as to when and where to invest. Passive mutual funds have existed since the 1970s. They garnered the interest of investors following the creation of the 401k plan in 1978, and really started to gain traction in the marketplace in the late 1990s. Assets in passive funds have been growing steadily ever since and represent over 40% of all fund assets now.
We can distill the main differences between active and passive investing into four categories:
Active investment strategies offer the possibility of higher returns, but not all portfolio managers can deliver. Outperforming markets has proven to be more difficult over time as markets have become more efficient. Just under one-quarter of actively managed funds outperformed the average of passive funds over the 10-year period ending in June 2020. Additionally, success seems to have little to do with cost. In fact, over the last 10 years the opposite has held true. The cheapest active funds succeeded 34% of the time, versus a 16% success rate for the priciest ones.
Because active investing requires constant oversight and more frequent trading, it costs more in terms of fees. As we’ve said, these higher fees offer the possibility of higher returns, but they can also eat away at the value of your portfolio.
A manager can decrease an investment’s weight or remove it based on changes in its underlying fundamentals. Passive fund investors are locked in. They cannot increase the weight of securities with better prospective returns and would have no ability to alter the risk profile of the portfolio. In addition, a passive fund may not include meaningful exposure to lesser-known small-cap stocks, which many managers believe have great potential.
While actively managed portfolios are generally less tax-efficient, that’s not the case for all investors. It’s worth having a chat with a financial advisor to see how various strategies may impact your tax situation.
While the differences between active and passive investing may be clear, choosing a direction that’s right for you may not be. Consult with a financial advisor you trust to find the right way forward.
Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Cobblestone does not provide tax or accounting advice; clients should also consult with licensed professionals in that field.