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    Investment strategy: Active, passive or both?

    Investment and Asset Management

    Stock market volatility during the last couple of years has reignited a long-running debate over active vs. passive investing. Both strategies have supporters and critics, and many experts advocate combining both approaches in a portfolio. As with most investment choices, the right strategy for you will depend on several factors, including your financial goals, investment expertise, time horizon and tolerance for risk. Before choosing or changing an investment strategy, learn more about active and passive investment strategies.

    Tracking an index

    Before defining what passive investing is, it’s helpful to explain what it isn’t. “Passive” doesn’t refer to individual investors’ roles in managing their portfolios. Rather, it signals the investment approach taken by fund managers or financial advisors. So, for example, a hands-off approach toward your portfolio isn’t passive investing if you place your assets in actively managed mutual funds.

    Generally, passively invested funds are designed to track the performance of a particular market index (such as the S&P 500 or Bloomberg Barclays U.S. Aggregate Bond) by buying and holding all, or a representative sampling, of the index’s securities. Passive funds typically have several advantages:

    • They’re highly tax-efficient because trading is kept to a minimum.
    • Their costs are typically low because they rely on formulas or algorithms rather than paying a team of analysts to evaluate individual companies.
    • Since their performance generally matches the performance of the relevant index, they usually have less downside risk than actively managed funds.

    On the other hand, passively managed funds can lack the upside potential of actively managed funds.

    But a passive strategy doesn’t mean there’s no decision-making regarding investments. Unless fund managers buy every security in the world, by definition they’re taking an active role in the fund’s investment choices. For instance, the manager of a fund that tracks the Russell 2000 index has made an active decision to limit the fund’s holdings to the 2,000 smallest stocks in the broader Russell 3000 index — a fraction of the securities available worldwide.

    Choosing securities

    Actively managed funds, on the other hand, generally rely on rigorous analysis to evaluate individual securities and create a portfolio designed to beat, rather than match, a market index. Managers usually buy and sell securities more frequently, generating capital gains, so these funds tend to be less tax efficient. Because they rely on expert analysis of possible investments, their costs are often higher — sometimes substantially higher — than those of their passive counterparts.

    The biggest advantage of active funds is that they have the potential to beat the market. But passive investing advocates point out that, more often than not, active funds fail to do so and in fact underperform relative to their benchmark market indexes. This is particularly true over the long term (see “A mixed track record for actively managed funds” at X).

    Arguing the merits

    But that doesn’t necessarily mean that passive investing is always the right choice. While recent history shows that active funds that focus on U.S. large-cap stocks have lagged behind passive funds tied to a U.S. large-cap stock index (such as the S&P 500 or Russell 1000), certain active funds perform much better. For example, in recent years, funds that invest in U.S. small-cap stocks and international large-cap stocks have, on average, outperformed their benchmark indexes.

    There’s some evidence that actively managed funds exhibit better short-term performance in certain market conditions. For instance, some analysts believe that active investing is more effective during periods of economic recovery when companies and industries perform inconsistently. The reason for this may be that actively managed funds have greater flexibility to avoid poorly performing companies or sectors. And they can deploy defensive strategies (such as increasing the fund’s cash position or investing in bonds) to minimize the impact of a falling market.

    Custom approach

    If you’re relatively risk-averse and are investing for the long term, passive investing may be more appropriate. On the other hand, if your risk tolerance is higher and you’re looking to beat the index over a shorter term, you may prefer active investing. Of course, a combination of active and passive vehicles can provide the best of both worlds — helping you to build a diversified portfolio.

    Given the uneven performance of actively managed funds relative to their benchmarks, it’s a good idea to look for funds with strong longer-term (for example, five- and 10-year) track records. But remember, historical performance is no guarantee of future results. Investments always carry the risk of loss. Ask your advisor about choosing securities that meet your particular needs.

    A mixed track record for actively managed funds

    Investment data company Morningstar has studied the records of actively and passively managed funds. According to its March 2021 Active/Passive Barometer report:

    • In 2020, 49% of active funds outperformed the average of their passive counterparts,
    • Over the 10-year period ending December 2020, only 23% of active funds beat the average of their passive counterparts, and
    • Long-term success rates were generally higher for real estate, bond and foreign-stock funds, and lowest for U.S. large-cap funds.

    These and other results outlined in the report support the idea that active funds are less likely to outperform passive funds over the long term. But investors may improve their chances of success by choosing active funds in categories where they’ve posted stronger track records.


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