Active and Passive Discussion

Combining active and passive strategies is a way to achieve another dimension of diversification within a portfolio. The conversation around active and passive strategies is not an either/or proposition as both can and do have a place. There is a role for both and reviewing the attributes of each can help construct a portfolio that serves your best interest. Know the reasons to consider and use both passive and active options as complements in a portfolio, depending upon market conditions and investor objectives.

View insights about active and passive from MFEA member firms on the Perspectives page.

Passive products allow investors a quick and cost effective way to get exposure to asset classes. Active products provide opportunities for managers to find information asymmetries and manage risk. Passive and active strategies should be considered for their merits in the pursuit of your portfolio goal and to reduce adverse effects. Keep in mind it is not just about returns as more complex strategies may provide the opportunity to produce superior investor outcomes

Portfolios that include both passive and active options can be highly complementary, offering the opportunity for results in excess of indexing along and/or for navigating market risks more effectively.

 

Investment Methods

There are two principle methods of managing money in mutual funds, exchange-traded and closed-end funds – they can be either actively or passively managed.

Actively Managed

Portfolio management decisions of actively-managed funds are made by professional investment managers and research teams whose goal is to deliver higher returns than their benchmarks. The term refers to the ability of the fund to make timely, active decisions to buy and sell securities depending upon market conditions and opportunities. Actively-managed funds are not required to hold specific stocks or bonds and have the ability to get out of a holding or market sector when risks get too large. They differ greatly from passively-managed funds (defined below), such as index funds, which match or track the components of a market index. Active managers combine research, market forecasting, and their experience to make decisions based on the goals set forth in the fund’s prospectus, which may range from narrow to wide. They offer the potential to outperform indexes over time, but also feature the possibility of underperforming them. Actively managed funds also have higher management fees than passive funds in order to pay for the professional teams that manage them. The following chart lists the differentiating features of actively-managed funds.


Active
• Achieve specific outcome, absolute return or certain level of income
• Broad diversification
• Experienced management
• Ability to react to market conditions

Passively Managed

Stocks in passively managed funds (i.e. traditional mutual funds) are not actively managed by a portfolio manager, but instead replicate an index like the S&P 500 and pursue index-like returns. This is the opposite of an actively managed fund (defined above). While actively-managed funds strive to outperform indexes over time, passively managed funds track the components of a market index to deliver the performance of the underlying index. However, the returns do not usually equal their benchmarks because trading costs are involved. Passively-managed funds tend to have low tracking error, which is a measure of how closely a portfolio replicates an index.

Passively managed funds also have lower management fees than active funds since they are not paying for professional teams to actively manage them. Passively managed portfolios often do not own every security in the benchmarks so portfolio managers try to reduce trading costs by holding only benchmark securities that track the benchmark’s overall performance.

The chart below shows the differentiating features of passively managed funds.


Passive
• Capture market return
• Low tracking error
• Reduced turnover
• Low-cost

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes based on measures such as volatility or dividends. Rather than weighting companies solely according to their size, smart beta uses fundamental analysis principles to determine which companies should be given a larger piece of the index pie. Smart beta strategies are popular for investors seeking factor diversification, but these strategies are not all alike. Carefully assess the indexes, biases and specific single or multi-factors each uses.

Active and Passive Risk

While each fund type has its own level of risk, there are different types of risk that vary by whether the funds are actively or passively managed.

For passively managed funds, a professional advisor is not able to manage volatility or take defensive positions in declining markets. The risk to be aware of in this situation is that your investment may be subject to greater losses during general market declines than actively managed investments, which are able to react in a timelier manner.

While an actively managed investment can buy and sell funds depending on market conditions and opportunities, it does not go without its own level of risk. A professional advisor’s use of investment techniques and risk analyses to make investment decisions may fail to perform as expected, which could cause the portfolio to lose value or underperform on investments with similar objectives and strategies.

While risk is a byproduct of investing, outperformance and underperformance have historically moved in cycles. Taking a consistent approach helps to mitigate downside risk, especially as some investors may look at the historical trends and try to buy passive strategies during bull markets (when share prices rise) and active strategies during bear markets (when market prices fall).