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Passive or Active Investment Strategies: Which Approach Is Better?

Insights & Ideas Team •  January 11, 2016 | Your Finances

Which is the better approach to investing: actively or passively managed funds? Ever since the first index fund was introduced nearly 40 years ago, there has been ongoing debate about which investment management style outperforms in the long run.

While each side scores valid points in its favor, it can be easy to lose sight of what might be an even more compelling argument: When it comes to building financial security for the future, it often takes a balance of both active and passive management to realize your investment objectives.

To understand why, let’s begin with a quick look at the basics of both approaches.

The difference between active and passive fund management lies primarily in the stated goal and the approach used to reach it. For example, passive (index-style) managers seek to achieve a return that closely matches the return of a specific index—nothing more, nothing less. This management style is considered “passive” because portfolio managers don’t make decisions about which components of the index to buy or sell; their job is to replicate the exact stocks or bonds, in the same proportions, as their benchmark.

In contrast, active managers aim to beat the return of a specific index on an absolute or a risk-adjusted basis through a combination of security selection and sector weightings. In other words, they research and select specific securities they believe offer the potential to outperform on a relative basis and reduce or avoid those securities or sectors they feel will underperform.

As the table below illustrates, there are certain benefits and tradeoffs of these two investment styles. For example, passive management maintains exposure to the market but doesn’t offer the potential to outperform the index or to limit exposure in a down market. What’s more, as individual stocks in an index do well and grow their market capitalization, they get assigned a greater weight in their respective index. Because passive managers have no ability to diversify away from those holdings over time, index investors can become heavily exposed to yesterday’s top performers.

In contrast, active managers can shift their portfolios to take advantage of market opportunities at any time. This gives active managers the potential to provide above-market returns; it also causes some to underperform. In volatile markets, active managers also can decide to reduce exposure or steer clear of weak sectors and companies they feel are overpriced or headed for a fall; passive managers don’t have that ability. Of course, all this research and discretion comes at a cost; typically actively managed investments will have higher expense ratios than their passively managed counterparts. 

 

Passive Management

Active Management

Buy-Sell Decisions

  • Based on index
  • Based on the manager’s qualitative and/or quantitative research

Potential for Meaningful Above-Market Returns

  • No (Passive strategy is designed to closely match the performance of a given index.)
  • Yes

Potential for Meaningful Below-Market Returns

  • No (See above.)
  • Yes

Ability to Limit Losses in a Down Market

  • No (Passive managers must hold all the securities in an index.)
  • Yes (Active managers have the ability to exit specific holdings or market sectors when risks get too large.)

Investment Management Fees

  • Generally lower than active management
  • Generally higher than passive management

Tax Efficiency

  • Typically tax efficient
  • Typically less tax efficient than passive management

Best of Both Worlds

Things are rarely black or white when it comes to investing in passively versus actively managed funds, and one approach may be favored over the other at any given time. For example, since 2008, index funds have become increasingly popular with investors, attracting $148 billion in new investment in 2014. This is up from $114 billion in 2013—an increase of 30 percent, according to the 2015 Investment Company Fact Book.

However, the debate between passive and active management is less Yankees vs. the Red Sox and more yin and yang than many investors realize. 

Evidence suggests that certain market conditions favor passive or active investment management. For example, passive management tends to shine during bull markets, when stock prices are rising quickly and growing companies in an index often are disproportionately rewarded. In contrast, active management generally outperforms passive management during flat-to-negative market periods, when stock prices aren’t all moving together and active managers have the ability to limit losses and uncover securities with greater upward potential than the rest of the market.

That said, there are exceptions in every market, and no one investment style outperforms consistently over the long term. For this reason, it may make sense to include both passive and active management as part of a well-diversified investment strategy.

Passive management can provide the consistency of index returns and cost advantages to your portfolio, while active management can add the opportunity for alpha (outperformance) along with the potential for downside market protection. Active management can also help you gain exposure to sectors of the market, like emerging-market and small-company stocks, where fewer analysts are watching; and an active manager may be able to spot diamonds in the rough.

Remember, a blended portfolio may provide some of the benefits of passive and active investment; it may also share in some of the trade-offs as well. For this reason, it’s important to discuss the pros and cons of each with your Northwestern Mutual wealth management professional. He or she can help you first identify your objectives and then determine which approach—passive, active or both—is most appropriate for you.

You should carefully consider the investment objectives, risks, expenses and charges of the investment company before you invest. Your Northwestern Mutual Investment Services registered representative can provide you with a prospectus that will contain the information noted above and other important information that you should read carefully before you invest or send money.

Indexes are unmanaged and cannot be invested in directly. No investment strategy can guarantee a profit or protect against loss.  All investments carry some level of risk including the potential loss of principal invested.

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