In building an appropriately diversified portfolio, investors have many choices, and investments have many different characteristics to evaluate. For example, is the investment designed to provide growth or income? Is it domestic or international? Does it have a maturity? Another consideration is whether the investment is actively or passively managed. Each style offers its own pros and cons – and the more you know about them, the better off you’ll be when it comes to making appropriate investment choices.
Passive and active management: The basics
The differences between passive and active management start with an investment index, or benchmark, such as the S& P 500. The manager of a passive mutual fund or exchange-traded fund (ETF) will seek to achieve the return of a particular index, before expenses – nothing more, nothing less. Typically, passive funds own most of the same securities, and in the same weightings, as their respective indexes. Passive fund managers make no “active” decisions, potentially resulting in less trading – which reduces fund expenses as well as potential taxable distributions to shareholders.
The performance of a passive fund should mirror the index it’s tracking, which means the fund will share both the ups and downs of the index. Most index funds and ETFs are passively managed. In contrast, an active manager will seek to outperform an index by achieving a higher return, taking lower risk or combining these two techniques. Because active fund managers choose investments, they have the potential to outperform the market on the upside and limit losses when the market declines, relative to the index. However, there is no guarantee that actively managed funds will outperform their index.
The table below summarizes the key benefits and trade-offs of these two investment approaches. (An index is not managed and is unavailable for direct investment.)
Passive vs. Active: Benefits and Trade-offs
• Likely to perform close to index.
• Opportunity to outperform index.
• Unlikely to outperform index.
• Potential to underperform index.
When should you consider passive management?
If the idea of lower expenses and the potential for better tax efficiency appeals to you, then a passively managed investment may be appropriate. However, with these benefits comes the trade-off of receiving index-like returns – on the upside as well as the downside.
When shouldn’t you consider passive management?
If the thought of participating in all of the downside of the market is unnerving to you, then you may be better served by investing in an actively managed fund that has at least the potential to limit the downside (although this is no guarantee). This potential does come at a higher cost, as the annual expenses of most active funds are generally greater than those of passively managed funds. There are certain areas of the market where we believe passively managed investments are not likely to be as effective as actively managed ones. The reduced liquidity of these areas makes it more difficult for a passively managed portfolio to achieve its objective of providing a return similar to the index.
Which style will outperform?
Many studies* have tried to determine whether the active or passive management style will outperform over time. These studies indicate the following:
Performance may vary, depending on the asset class.
Performance may move in cycles – and there will likely be years when even the “best-performing” style may not have positive returns.
In evaluating whether active or passive management outperforms, it’s important to realize that the asset class can often influence the results. For example, some asset classes, such as large-cap equities or investment-grade fixed income, are larger and more established, which might make it harder for an active fund manager to outperform the index. Remember, this doesn’t mean active management doesn’t work in certain asset classes – many active managers outperform regardless of their asset class. It just means it can be more challenging to find managers who might outperform in certain asset classes. On the other hand, in less efficient asset classes – such as small-cap, mid-cap or international equities – active portfolio managers may have a greater opportunity to outperform. Information on these types of companies is likely less widely available, which creates potential opportunity for managers willing to conduct deeper analysis to outperform, although it is certainly not guaranteed. Performance May Move in Cycles – Not only does the outperformance of active or passive management often vary by asset class, it can also vary based on the market environment. For example, when the market has momentum and is showing strong returns, it might be more difficult for actively managed funds to keep up with the index. The reason is that these funds hold different securities from the index, as well as small amounts of cash. However, in weak or declining markets, active managers’ funds might have the potential to hold up better, perhaps by becoming more conservatively positioned when markets become choppy.
Determine what’s most important to you
We believe both active management and passive management can play a role in your portfolio. It’s really about evaluating what you want from an investment and prioritizing what is most important to you. We recommend you talk with your advisor to help determine which investments are most appropriate for you. ETFs and mutual funds are offered by prospectus. You should consider the investment objective, risks, and charges and expenses carefully before investing. The prospectus contains this and other information. Your Edward Jones advisor can provide a prospectus, which you should read carefully before investing. Your investment return and principal value will fluctuate, and you may lose money.
*“The Case for Indexing,” Vanguard Investment Counseling & Research. Copyright 2009, The Vanguard Group.
Diversification does not guarantee a profit or protect against loss.