Contributed by: Mallory Hunt
Tale as old as time? Not quite, but the active vs. passive management debate is a familiar one in the financial industry. An already intense deliberation has turned up the heat a couple of notches during the most recent market turmoil. So which one wins, and how does it affect you and your portfolio? Let’s start with the basics.
Active Management- What Is It?
Active management is an investment strategy in which a portfolio manager’s goal is to beat the market, take on less risk than the market, or outperform specific benchmarks. This strategy tends to be more expensive than passive management due mainly to the analysts and portfolio managers behind the scenes doing the research and frequent trading in the portfolios.
When the market is volatile (sound familiar?), active managers have had more success in beating the market and those benchmarks. Scott Ford, the president of affluent wealth management at US Bank, claims that “active managers probably do their best work in times like this of market dislocation and stress.” In the first half of 2022, 58% of large-cap mutual funds were beating their respective benchmarks.
Even after the decline throughout the rest of the year, actively managed funds were down roughly 5% less than the S&P 500 over that same period. Much can be said regarding outperforming on the downside, and risk management is one of the potential extras investors may receive with active funds.
And Passive Management?
On the other hand, passive management is an investment strategy that focuses more on mirroring the return pattern of certain indexes and providing broad market exposure versus outperformance or risk mitigation.
Conversely to active management, with no one handpicking stocks and trading happening less frequently, this allows passive funds to pass on lower costs to the investor and tends to assist in outperformance when put up against active funds in the long term. These funds tend to be more tax efficient and do not typically rack up much in terms of unexpected capital gains bills unless you are exiting the position, giving you control over when the capital gains are taken. In turn, the less frequent oversight provides little with regard to risk management, as investors own the best and worst companies of the index that the fund tracks.
This easy, cheap exposure to an index has caused an influx of funds over the past four years or so, and we are at a point where passive funds (black line) have actually superseded active funds (yellow line) in the US domestic equity market as evidenced by the graph below.
So, Whose Time Is It to Shine?
As with most things, while both strategies have advantages and disadvantages, the answer may not be so black and white. The question may not be active OR passive, yet a combination of the two; this does not have to be an either/or choice. We have extensively researched the topic and implemented a balanced approach between the two in our portfolios.
Just as the market is cyclical, so is that of active and passive management. Both skilled active management and passive investing could play an important role in your investment strategy. This can be even more applicable after periods of volatility, as investors close in on meeting their investment goals.
In certain asset classes, such as US Large stocks, consistently achieving outperformance for active managers has proven more complicated, and it may make sense to rely more on passive funds. In areas like International stocks and emerging markets, it may be helpful to depend on active management where it has historically proven more beneficial.
When all is said and done, there will never be an exact strategy that works for everyone; the correct mix will still depend on you and your investment goals on a case-by-case basis.
Source: “Active vs. Passive: Market Pros Weigh In on the Best Strategy for Retail Investors”, Bloomberg News August 2022
Mallory Hunt is a Portfolio Administrator at Center for Financial Planning, Inc.® She holds her Series 7, 63 and 65 Securities Licenses along with her Life, Accident & Health and Variable Annuities licenses.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the Mallory Hunt, and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Past performance may not be indicative of future results.
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