Investors today live in an era offering unprecedented global investment choices, in both active and passive vehicles. Investments in each category have opportunities and challenges for investors to consider when crafting an optimal financial strategy. With so many choices at your fingertips, how can you best capitalize on what the markets have to offer? There is no right answer for everyone, but in many cases, it may make sense to use both active and passive investments to effectively build and manage a diversified portfolio.
Defining active and passive investing
Active investing is an approach that seeks to capitalize on inefficiencies in the market by identifying individual securities that don’t currently appear to be priced based on their true underlying value. Success using this approach generally requires in-depth research and analysis by knowledgeable investment professionals. Many traditional mutual funds fall into this category. Active fund managers who oversee these funds seek to generate returns that outperform a benchmark, or a specific measure of market performance, such as the S&P 500 index. They make investment decisions based on a defined approach or strategy.
Passive investing is an approach that seeks to match the performance or a specific benchmark or segment of the market. Many passive investors choose, for example, to put their money to work in an index fund that invests in a broad segment of the market. Perhaps the most common passive investments are funds that track the performance of the S&P 500 Index, an unmanaged index of large capitalization U.S. stocks. The premise is to own a broad cross-section of the market, or of a segment of the market, rather than trying to identify specific securities that may outperform a benchmark or segment of the market.
It’s worth noting that there are increasingly more investment options offering a middle ground between active and passive strategies. Called strategic or smart beta, this investment strategy combines the transparency, consistency, and cost-efficiency of passive investing, with the investment insights found in active management.
Considerations for each approach
There are benefits and shortcomings to each approach. Actively managed investment strategies offer the opportunity for outperformance versus a specific segment of the market. They can also take steps to defend against the impact of down markets that inevitably occur from time-to-time, often by avoiding individual securities or sectors that have challenges. To accommodate the research and expertise involved, actively managed investments typically come with higher expenses, which detract from the net returns they generate. Also, because they are using a selective approach to investing, there are times when they will choose to invest in securities that don’t perform to expectations, and perhaps miss out on the full benefit of broader upward trends in the market.
A key benefit of passive investing is that fees tend to be lower than other investment strategies. They also tend to be tax efficient because trading is minimized in the fund as it continues to track an index over the long term. A downside to passive funds is that by simply investing in a benchmark, an investor foregoes the opportunity to outperform that index. This means returns tend to match those of the market, minus any fees. Also, in volatile periods or when markets trend down, index fund investors will see their investments follow a similar path.
A case for both strategies
Is one approach the best choice for your portfolio? The reality for many investors is that a combined approach may be an effective solution. Investors should pay close attention to factors that can affect their investment results, including fees, different sources of potential investment return and the benefits of a diversified portfolio.
You may determine that part of your portfolio should generally track with the market. If that’s the case, a passive fund may make sense. At the same time, you may want to take advantage of specific opportunities in segments of the market where selectivity may help you reach your goals. If so, active strategies may offer a better path to success.
The good news is that you have a tremendous opportunity to effectively diversify and tailor your portfolio to help you achieve your long-term goals. A financial advisor can work with you to determine what approach and investments work best given your financial goals, investment time horizon and risk profile.