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Active vs. Passive Management: What To Choose?

There are two types of portfolio management: active and passive. Which is better is a hotly contested question within the field of investment management. Like most hotly-contested questions, the answer is complicated. Each type of portfolio management has its advantages and disadvantages, and the right option depends on your goals.

In this post, we’ll break down active and passive management by comparing critical aspects of both so that you can make an informed decision on how to should invest your hard-earned money.

First things first, what’s the difference between passive and active management?

Passive Management

Let’s start with passive management, also known as index fund management. The goal of passive portfolio management is to match the returns of a specific index. The index a fund attempts to match (or outperform for actively managed funds) is known as the benchmark.

Passive management may create a broad market portfolio or a highly specialized one. It all depends on the benchmark the strategy is attempting to track.

For example, the S&P 500 consists of the 500 largest U.S. publicly-traded companies. It is considered one of the best indices for tracking the return of the entire U.S. stock market and is, therefore, a popular option for funds attempting to replicate the performance of the overall market. But passively managed funds aren’t limited to broad market indices.

A passively managed portfolio may also track a specific industry, geographic location, market cap, strategy, etc. For example, a passively managed fund attempting to follow the tech industry may track the NASDAQ 100 Technology Sector Index, which consists of the top tech stocks.

An important note about passively managed funds is that you cannot invest directly in an index. This means that though passively managed funds attempt to mirror the returns of their benchmark index, that does not mean the fund will match the returns. It’s possible for the performance of a passively managed index fund to differ from the returns of the index it’s tracking. This difference in results may occur for a variety of reasons, such as higher turnover (which leads to higher transaction costs) and tracking errors.

There are also fees to consider. An index is a collection of securities with no fees impacting performance. In contrast, a passively managed fund will always have expenses that will cut into performance.

Active Management

The other type of portfolio management is active portfolio management. The goal of active portfolio management is to outperform a specific benchmark or index.

An active portfolio manager is what people have in mind when thinking of portfolio management. An active portfolio manager, often with the assistance of a portfolio management team, conducts research, studies market trends, tracks the political landscape, and then attempts to use this information to buy and sell securities in such a way that outperforms the market.

Like passively managed portfolios, actively managed portfolios may use a broad market index, such as the S&P 500 as their benchmark. They may also focus on more specialized areas.

Active portfolio management typically comes with more risk, but by its very nature, it offers a higher potential for reward. If passive management achieves its goal, it would only provide returns that match its benchmark before accounting for fees. On the other hand, if active management accomplishes its mission, it performs better than its benchmark.

It’s worth noting that just because the goal is to outperform the market, that does not mean that all actively managed funds beat the market. Beating the market is challenging and requires finding a knowledgeable and experienced portfolio manager.

The Rise of Passive Investing

Only recently has passive investing seen massive growth. Before we get into our comparison of active and passive portfolio management, let’s take a moment to look at how we got here.

Though the concept of tracking an index has been around longer, the first true index tracking fund was started in 1976 by Jack Bogle, the founder of Vanguard. At the time, the finance industry found the concept of an index fund absurd and even “un-American”. Regardless of the ridicule, index funds began to grow in popularity. Their growth was steady for decades, but after the 2008 financial crisis, investment in passively managed funds skyrocketed.

Before the financial crisis, the index fund industry was worth $2 trillion. While substantial, this is nothing compared to its current value of $10 trillion. That’s a five-fold increase in only a little over a decade. This trend has been fueled in large part by the surge in investment technology that has occurred since the financial crisis.

The explosion of passive investing aligns with the genesis of robo advisers. Robo advising has had a considerable impact on the finance industry. It’s helped to lower the barrier of entry to many investors and offers a simplified investing experience.

At the outset, robo advisers relied heavily on passively managed index funds. Though robo advisers have begun expanding into more services and offerings, including more opportunities to invest in actively managed funds, their primary offering remains passively managed funds.

Does the growing popularity of robo advisers and passive investing mean the end of human advisers and active portfolio management? Not by a long shot. The simplicity of robo advising, one of its most significant advantages, is also arguably one of its biggest disadvantages. Investing is not one-size-fits-all. Robo advisers cannot create highly personalized portfolios or to provide the same level of personal support and advice that an advisor can. In short, robo-advising and passive investing may continue to grow, but advisers and active management aren’t going anywhere.

Comparing Active and Passive Management

Now that we have a better understanding of what passive and active portfolio management looks like, it’s time to dig a bit deeper. We’ll now compare active and passive management in the following seven areas.

Returns Fees Taxes Investment options Flexibility Risk Ability to hedge

Let’s start with everyone’s favorite: returns.

Returns

As previously mentioned, by their very nature, actively managed funds offer a higher return potential, but that doesn’t mean all portfolio managers can deliver. Many studies have shown that when comparing passive to active portfolio management, as a general rule, more active managers lag behind their benchmarks than beat their benchmarks.

Why is that? Simple - active management is difficult.

But difficult doesn’t mean impossible. Some active managers can outperform the market, but they aren’t always easy to find (more on this later).

So, what exactly do the numbers tell us? In 2018, only a little over a third of active managers of large-cap funds managed to outperform the S&P 500. As I said, active management isn’t easy. But there are areas where active management continues to outperform passive management. These areas tend to be higher risk environments where inefficiencies can be exploited. High-quality active managers can then use their skills and experience to beat passively managed strategies.

One of the best examples of a high-risk environment with plenty of inefficiencies is emerging markets. This also happens to be one of the areas where active management has outperformed passive management. Passive emerging market funds saw an annual average return of only 2.5% over three years. In contrast, active managers of emerging market funds with at least $100 million saw gains of 4.8% over the same period.

Specific periods also tend to favor active or passive portfolio management. In general, active management is viewed more favorably during a bear market. During a period of substantial market gains, active management may provide steady returns but often fail to outperform the high returns of the market.

Returns matter, but we can’t talk about returns without also accounting for fees, which is where we’ll turn our attention to next.

Fees

Generally, active management has higher fees than passive management. Fees have been one of the biggest draws for passive investors.

Investors have little control over many aspects of their investments. An investor can’t control which investments are in a fund, the performance of the fund, the ups and downs of the market, or many other factors. One of the few factors investors can control is how much they pay in fees. Since this is one of the few areas investors feel they can control, many investors choose the option with the lowest possible fees. While using only one factor to evaluate an investment can lead to missing out on potential opportunities, fees can have a huge impact on your portfolio.

In an SEC investor bulletin highlighting the impact of fees, the SEC provides an example to highlight just how much fees can impact overall returns. If you had a 4% annual return on a $100,000 investment, over 20 years, you would earn almost $30,000 less if you had a 1% fee than if you had a 0.25% fee—clearly, fees matter.

While it’s essential to remain mindful of fees, it’s also important to remember that the power of compounding applies to returns as well as fees. If you find an active manager that can outperform the market (even by a small amount), that little difference in performance can lead to much higher returns over the long run.

Taxes

Tax implications may not always be front of mind - but taxes eat into any returns or income you may see and should therefore always be considered.

When it comes to the passive vs. active management discussion, there’s no one strategy that’s always better from a tax perspective. Instead, the better option depends mostly on your financial situation. Passively managed portfolios have a reputation as more tax-efficient than actively managed funds. In some instances, this may be the case. For higher net worth individuals, though, the complexities of their portfolio often mean that an active approach provides superiortax efficiency.

The “better” option from a tax perspective will depend mainly on what your needs are. Regardless of which approach to portfolio management you ultimately take, it’s always worth taking the time to make sure you fully understand the tax implications of any investment decisions.

Investment Options and Flexibility

Another difference between passive and active portfolio management is the investment options, and therefore the level of flexibility, each provides. Actively managed funds provide far more flexibility because they’re not limited to specific investment options the same way passively managed funds are.

Passively managed funds must do their best to mirror the index they track. This means they are locked into specific investments. If certain investments in a fund perform poorly, those investments remain in the fund. The only way an investor could avoid exposure to certain poorly performing investments in a passively managed fund would be to sell all shares of that fund. The opposite is also true. If a specific security is performing well but is not part of the index the passively managed fund is tracking, then the fund cannot include that security and, therefore, cannot benefit from its performance.

On the other hand, active management has far more flexibility. If a security is performing poorly, an active manager can remove that security from the fund. And if a portfolio manager finds a security that shows a lot of potential, the portfolio manager could include it in the fund, whether or not the benchmark index contains that security.

A portfolio manager of an actively managed fund can not only choose which securities to include in the fund, but the portfolio manager can also control the weight of the securities in a fund. This means an active portfolio manager may have the same securities in a fund as the benchmark, but with different weights of each security. An actively managed fund could, therefore, outperform the benchmark, even if it owns the exact same securities.

Clearly, the flexibility that comes with more investment options provides some potential benefits to active managers. But it’s not without its disadvantages as well, which brings us to our next point.

Risk

In general, active investing comes with more risk than passive investing. Strategies that chase higher levels of performance often come with increased risk. And while the potential strategies a manager can implement to increase her returns are near endless, I’ll provide three common examples below.

Concentration - Portfolio managers often are less diversified than the benchmark they track, and often they’ll concentrate on their favorite ideas hoping to boost returns.

Riskier Assets - Managers may incorporate riskier, small-cap stocks that they believe have a lot of potential. These securities may carrier higher default risk, and their returns may be more volatile.

Slippage & Fees - A manager may also trade in and out of stocks frequently, trying to achieve additional returns but falling short left with a large trading bill.

Ability to Hedge

Passive managers can’t invest in securities not included in the index their fund tracks, which means that unlike active managers, they can’t hedge.

Hedging is a way to protect a portfolio by reducing exposure to certain investment risks. You can think of it as investment insurance (though unlike insurance, it doesn’t typically cover all losses). Most commonly, hedging involves options or futures. A plethora of hedging options exist, but ultimately, you can use options or futures to protect yourself from losses. For example, if you believe Company A is an excellent long-term investment but have some concerns about short-term volatility, you could purchase a put option. This will allow you to sell your stock if the stock falls to a certain price. This way, even if you lose money in the share price, you make money on the put option.

Hedging is far from perfect, but it can be an excellent investment tool when used wisely. Hedging is common among active managers and can help to offset some of the additional risks that come with active management. In fact, a considerable advantage of active management is that active managers can implement risk mitigation strategies, while passive managers cannot.

Much like other areas we’ve looked at, whether hedging occurs and how well it is done, depends mostly on the quality of the portfolio manager. Therefore, finding an active portfolio manager who can outperform the market is key. But how can you do that? That’s what I’ll explore next.

What to Look for in an Active Portfolio Manager

We’ve compared a variety of different aspects of active and passive portfolio management. As you’ve likely realized by now, what it ultimately comes down to is whether an active portfolio manager can outperform the benchmark and can do so at a level that makes it worth the higher cost. If you can find these portfolio managers, then active portfolio management is the better choice. If you cannot, then passive management becomes the better option.

No perfect strategy exists for finding an active portfolio manager who can outperform the market. Even if a portfolio manager has outperformed the market in the past, that isn’t a guarantee that the portfolio manager can do so in the future. That being said, there are a few things you can look for when selecting an active fund manager. We’ll conclude this post by touching on a few of these.

Incentivized to Perform Well

First of all, you want a manager whose compensation is tied to outperforming the benchmark. It’s also a good sign if the portfolio manager has some of his or her own money invested in the fund. This means the portfolio manager is incentivized to perform well and believes in the fund. You can find this information in the prospectus for the fund.

Time to Focus on The Fund

As we’ve seen, managing a portfolio is difficult. It requires not just knowledge and experience but time and energy. Therefore, it’s not usually a good sign if the portfolio manager is the lead manager for many different funds. While two or three is reasonable, more than three is typically a bad sign. You want the portfolio manager to have enough time to focus on the fund you’re investing in, and acting as lead manager for more than three funds makes this incredibly difficult. This information should also be included in the fund’s prospectus.

Consistency

You’ll also want to look for a portfolio manager with a consistent investment strategy. The opposite of consistency is style drift. Managers may attempt to improve returns in the short-term by drifting from their typical style. The best way to check for style drift is by reviewing the fund’s quarterly 13F and looking at the holdings listed.

You can also use the information ratio to compare a portfolio manager’s consistency. The information ratio takes the difference between the return of the portfolio manager’s fund and the return of the benchmark index and divides it by the standard deviation of the active return. By looking at the information ratio, you can determine if a portfolio manager has consistently beat the market a little bit over time, or if the portfolio manager outperformed the market by a lot for a short period. If the portfolio manager has consistently outperformed the market, there’s a much better chance that this is due to the skill of the portfolio manager, as opposed to merely luck.

Performance

When comparing the performance of various portfolio managers, it may seem like going with the portfolio manager with the highest performance is your best bet, but this isn’t necessarily the case. Often the top performers have taken on high levels of risk to achieve these results. While their luck may continue to hold, it’s also possible that the high level of risk they’re taken on is about to catch up with them. You want a portfolio manager who can outperform the market, but not one who attempts to do so through taking on an excessive level of risk.

Previous top performers may also have overpriced portfolios. This would make outperforming the market in the future far more difficult. One way to check whether or not a portfolio manager is willing to trade into securities that offer a better value, even if they are out of favor, is to compare the fund’s price-to-earnings ratio (P/E) from three years ago to the fund’s current P/E.

Turnover Rate

Active management naturally has a higher turnover rate than passive investing, but there’s a fine line between typical turnover and unnecessarily high turnover. High turnover means more transaction costs and tax liabilities, which cut into your earnings. It’s therefore typically preferable to avoid funds with unnecessarily high turnover. The exact amount of turnover will vary depending on the strategy. Still, you’ll usually want to avoid funds with turnover ratios over 100% percent, which means that the portfolio manager has turned over the entire portfolio within the last year.

Size of the Fund

Larger funds often provide investors a feeling of security. The logic often runs something along the lines of, the larger the fund, the better it must be. But this isn’t necessarily the case. To a certain level, a larger fund may be a good sign, but over a certain point, the size of the fund may become detrimental. Moving massive amounts of money takes longer, which slows down the ability of the fund to execute a strategy. It depends on the fund, but generally, any fund with over $100 billion in assets may be hampered by its own success.

The Takeaway

The debate over active and passive management is unlikely to end anytime soon. While plenty of factors come into play, what it all comes down to is whether or not you can find an active manager who can outperform the market.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.