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Ask the Financial Expert: The Pros and Cons of Passive and Active Investments

Ron Joelson •  April 5, 2016 | Your Finances, Ask the Expert

Each month, we book time with some of our company’s top financial brain power to answer questions about investing and your finances. This month we’re discussing passive and active investing strategies.

Ron Joelson

Ron Joelson is Northwestern Mutual's chief investment officer and oversees the company's general account, valued at approximately $200 billion as of June 2015.

Mark McLennon

Mark McLennon is vice president of Investment Products and Services (IPS) Business Development. He oversees the fee-based financial planning program and departmental growth initiatives.

Brent Schutte

Brent Schutte is chief investment strategist of Northwestern Mutual Wealth Management Company. He oversees the investment philosophy for individual retail investors and the investment strategy for more than $100 billion in assets under management as of February 2016.

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The following is an excerpt from our Ask the Financial Expert podcast (listen to the entire podcast below):

Mark: It’s been an interesting year. We’ve seen a lot of volatility in the market. One question we often hear is whether investors are better off in actively managed vehicles or passively managed vehicles. Ron, can you give us a quick overview of active and passive investing?

Ron: The best way to think of active management is that you’re paying a manager to beat the market. That doesn’t mean they always will; they may underperform. In a passive strategy, you’re buying the market, and so you have almost no risk that you’re going to be under the market and very little likelihood that you’ll be above it.

The passive strategy as it follows an index also tends to be more tax efficient. While some active managers can mitigate taxes with a tilt toward tax-efficient investing, generally an active strategy isn’t as tax advantageous because capital gains tend to be a big part of the active strategy.

Sometimes an active strategy can be better in a 401(k) or a qualified type investment, where those gains are going to be less problematic from the tax perspective. On the other hand, a passive strategy may be better for a non-qualified market, in which you will pay taxes on gains.

So active, think beating the market. Passive, think buying the market.

One thing I would add on passive investing: There are some practitioners out there who say there’s almost no such thing as truly passive because, unless you buy a complete global financial asset portfolio, it’s very difficult to buy the entire market. So even some of the passive strategies that are out there, you’re making decisions.

Mark: Brent, how would clients know which one might be better for them?

Brent: In general both of them can have a place in your portfolio. But you need to know and understand what you’re buying and why you’re buying it. We use both strategies in our business, and we use them for various reasons.

If you’re buying a passive vehicle, you’re buying the index, and you want to make sure that you know you’re doing that. If you’re buying an active manager, you have the ability to outperform or underperform the index. As so, that means you are going to underperform a lot of time. Where individual investors run into trouble is the typically sell at the wrong time—when a manager is underperforming. That’s an important point: Any investor should know they will need to be willing to hold the fund during these periods to get the longer-term (hopefully) outperformance.

Ron: It’s important to not forget that this has been a period of time where passive strategies have done quite well. Over the last five years probably more than 85 percent of large cap managers underperformed the S&P 500, and probably more than 80 percent over the last decade. Generally speaking, in good times when everything’s going up, it has been better for the passive managers and passive strategies. But I would say that when there’s been trouble—think of 2001 and 2002 or 2008 and 2009—those are periods of time when active managers were able to do certain things that were really helpful. For instance, an active manager is able to get out of certain names quickly and not let the downside of an Enron or a WorldCom take down performance. That’s why I think Brent’s point about having both strategies can be really important, particularly over long cycles.

Brent: Here’s another way to think about it, if a bunch of people are buying passive vehicles and they’re buying them all in one fell swoop, every stock goes up or down based upon that one decision. What that would mean to me is that the people who are doing the research have the ability to take advantage of miss pricing. These occur because someone bought a whole slug of stocks in an index, causing those stocks to go up based upon something other than their underlying fundamentals.

Hear more from Ron, Brent and Mark in the “Ask the Financial Expert” podcast:

Do you have a question for our financial experts? Email it to us at:

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.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities) and its subsidiaries. Northwestern Mutual Investment Services, LLC (securities), subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI (fiduciary and fee-based financial planning services), subsidiary of NM and federal savings bank. 

The opinions expressed are those of Northwestern Mutual as of the date stated on this recording and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. All investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. Commodity prices fluctuate more than other asset prices with the potential for large losses and may be affected by numerous factors, such as market, regulatory, weather, political, economic and competition factors. Investments can be made directly in physical assets or commodity-linked derivative instruments. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise; and conversely, when interest rates rise, bond prices typically fall. Bond and bond fund investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.

Typically, expenses for an active investment are higher than for a passive investment.

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