Active or passive investing: The pros and cons of each

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January 05, 2018

Google the phrase “active vs. passive investing,” and you’ll get some 64,000 hits, demonstrating that this is a two-sided debate with many vocal participants. “But it’s a mistake to view either approach as inherently superior to the other,” says John De Clue, Chief Investment Officer for U.S. Bank Private Wealth Management. “The reality is that most investors can be well-served by a combination of active and passive strategies.” 


As the term suggests, active investing relies on the skills and judgment of a portfolio manager who seeks to outperform the market by choosing investments matched to the client’s objectives, moving in and out of positions to take advantage of pricing inefficiencies. In contrast, a passive strategy aims to duplicate the returns of an index, such as the Standard & Poor’s 500 or the NASDAQ Composite, by mirroring its holdings and not including any independent buy or sell decisions. 


While active and passive strategies each have their advantages, investors have been fleeing active managers in droves over the past decade. According to Morningstar, investors pulled more than $285 billion from actively managed U.S. equity mutual funds in 2016 and sent more than $428 billion flowing into passive stock funds, including index funds and exchange-traded funds (ETFs). ETFs are marketable securities that track an index, index fund, commodity or bond and trade like common stocks on a stock exchange.


The pros and cons of passive investing


“The case for passive investing is fairly straightforward and derives from the overall efficiency of the market — meaning that the prices of most securities will reflect their actual value and that the same information is available to all investors,” says Peter Braude, Research Analyst for U.S. Bank Wealth Management. “That makes outperforming difficult.”


A passive strategy is designed to meet — not beat — the performance of its benchmark, potentially reducing the risk of underperforming the market. It’s a simpler way of investing, with no opportunity for market timing, stock selection or other human intervention. Because any changes in the underlying index will be automatically replicated in an index fund, the returns will ideally track those of the index. 


There are other differences as well — such as greater transparency and lower fees. “ETFs are totally transparent — you can see exactly what’s in them at all times, and you can buy and sell them throughout the trading day like stocks,” Braude says. Transaction fees, management expenses and capital gains taxes are significantly lower than those for actively traded accounts. And, unlike mutual funds, which are typically re-priced just once a day, ETF prices are updated constantly, so you always know their exact value.


At the same time, passive investing also comes with caveats. “ETFs are not risk-free investments,” De Clue says. “For one thing, you’re exposed to the risk of the underlying securities, which can be exacerbated by market or political instability.”


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January 05, 2018

The explosive growth of ETFs also has raised concerns about quality. “It’s no secret that some companies have rushed ETFs to market without establishing adequate tracking mechanisms,” De Clue adds. In some cases this has led to tracking error — a discrepancy between ETF and fund performance. 


“There is no guarantee that an ETF will duplicate the return of the index,” he says. “People generally buy an ETF with the expectation that its returns will reflect that of the underlying index. But if the ETF isn’t properly managed, they could be in for an unpleasant surprise.” 


U.S. Bank employs rigorous due diligence in evaluating and selecting ETFs and index funds, De Clue says, weeding out those we believe are “unlikely to track what they should be tracking.” 


The pros and cons of active management


Active management, by comparison, is anything but simple; however, the nuances and complexities can be a major plus. “Unlike their passive counterparts, active managers have a chance to beat their benchmark,” De Clue says. 


Admittedly, studies have shown that a significant number of active managers struggle to outperform their respective benchmarks at any given time, and this has been a concern within the investment management industry for a number of years. “That said, active managers have a much wider universe of investments to choose from and may be in a better position to manage risk, diversify holdings and profit from short-term market fluctuations, mispricings and other inefficiencies.” 


For example, a passive investor could buy an ETF that tracks the Morgan Stanley Emerging Markets Index and gain immediate exposure to companies in Asia, Latin America and emerging Europe. “In contrast, an active portfolio manager could look for opportunities for excess reward within that same investment universe, overweighting some countries and underweighting others, based on quantitative and qualitative research — all in an effort to beat the index,” De Clue says.  


Additionally, active management offers a variety of other potential benefits, including:

Flexibility: Managers are not required to hold specific stocks or bonds.

Hedging: Managers can use short sales, put options and other strategies to guard against losses.

Risk management: Managers have the ability to get out of specific holdings or market sectors when risks get too large.

Tax management: Advisors can tailor tax-management strategies to individual investors — for instance, by selling investments that are losing money to offset taxes on big winners.


To be sure, the freedom to depart from the index comes at a cost, measured in the potential for loss of principal, steeper fees, potentially higher taxes and the very real risk of falling short of the benchmark. Investors should always read the fund prospectus, which identifies strategies and additional risks.


The importance of persistence


Whichever investment approach better suits your needs, Braude advises, be prepared to stick with it for the long term. “When an active strategy falls short over the course of two or three quarters, people may be tempted to give up on it, rather than continue to pay hefty management fees for a strategy that isn’t working for them,” he says. 


It’s a textbook example of performance-driven behavior. “People get uncomfortable and feel they should make a change,” De Clue says. “But they make it at exactly the wrong time, entering a market when prices are high and exiting when they’re low.”


Ultimately, investors should weigh the benefits and suitability of active and passive investing within the context of their total portfolio perspective. 


“There is no absolute way — or need — to declare active or passive investing the only way to go,” De Clue says. “Both are viable options. It needn’t be an either-or decision.”




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