Active Versus Passive Management Strategies

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Published: June 12, 2024

Active versus passive: Actively and passively managed strategies are often thought of as mutually exclusive, whereby investors must choose one approach over the other, yet both can coincide in a portfolio to drive returns to help reach your goals.

Active and passive investment management strategies often seem a loggerheads with proponents of each approach exulting their benefits while highlighting the disadvantages of the other.
Boosters of active investment management contend that expert managers help find opportunity while navigating risks that ultimately lead to outperformance of a broad-based index like the S&P TSX Composite Index over the long-term.
Proponents of passive investing, which involves essentially buying a portfolio of securities that mirror the performance of an index like the TSX Composite, contend the approach is superior due to its significantly lower fee structure.
As well, passive boosters often cite research showing most active managers frequently fail to outperform their benchmarks.
This can leave many investors feeling torn.
Certainly, both have their unique advantages and disadvantages.
Yet investors can leverage both to their advantage in one portfolio as opposed to dogmatically adhering to one over the other.

Let’s take a closer look at these broad approaches to investing and how they can address needs for many investors even in the same portfolio.

 

Active investing

The pros:

  • First and foremost, an active strategy allows money managers to adjust the portfolio to align with market conditions to reduce risk. For example, an equity fund’s active manager expecting a change for the worse in economic conditions can adjust the portfolio to hold fewer risky investments—like speculative technology stocks—and hold more defensive stocks–like consumer staples.
  • Active management can also take advantage of short-term market opportunities with the ability to invest in securities that will benefit from these conditions, increasing the likelihood of outperforming the broader market.
  • Active management also can address a broader array of outcomes for investors’ specific needs. For instance, active management can tilt a portfolio to be more tax-efficient for retirees, generating higher dividend income than a passive approach that mirrors, for example, the S&P 500 index.

 

The cons:

  • Active management can be costly. Management fees—often referred to as the management expense ratios (MERs) for mutual funds are typically much higher than passive strategy funds. For example, a Canadian equity mutual fund run by an active manager might charge an MER of two percent per year, whereas a passive ETF tracking the TSX Composite’s performance might charge less than 0.1 percent per year. What’s more, research shows most active managers struggle to outperform their benchmark often due to the higher fees they charge.

 

Passive management

The pros:

  • Passive management generally involves holding a fund—often an ETF—that mirrors the performance of a benchmark index, like the NASDAQ or the FTSE Canada Universe Bond Index. As a result, it always captures the best-performing securities on the index. By comparison, an actively managed fund is not guaranteed to hold the best-performing securities on its benchmark index, leading to underperformance of the index. To that end, an S&P Global report from 2023 shows that since 2001, the majority of large-cap U.S. equity funds have underperformed the S&P 500 in all but three years.
  • Passive strategies are often more tax-efficient than active ones, particularly given they generally involve less turnover of securities triggering taxable events. In contrast, active management can involve more trading, which results in more realized, taxable capital gains.
  • Passive strategies are less complicated than active ones. Investors essentially can buy and hold a passive, broadly diversified ETF–a ‘set-and-forget approach’–because the goal is owning the whole market. This is especially advantageous because it helps investors avoid the temptation to sell low in falling markets and to buy high in peaking ones.

 

The cons:

  • Passive strategies may hold all the market’s upside, but they also hold all its risks. In turn, a Canadian equity ETF could be heavily exposed to a large company that experiences a significant decline in its share price from deteriorating business conditions. Yet an active manager can mitigate this risk, reducing exposure to this stock.
  • Passive approaches also can limit returns in flat market conditions, whereas active managers can invest in faster growing parts of the market while avoiding those areas that are facing flat growth or even declining profitability. The S&P Global report suggests as much, showing that in 2009, following the 2008 financial crisis, 52 percent of active managers outperformed their benchmark, the S&P 500.

A hybrid approach

Investors don’t have to choose one strategy over the other. In fact, a strong argument can be made that both can be used effectively in one portfolio. Look no further than institutional money managers (i.e. pension funds), which have used a combination of passive and active strategies for the past two decades. Passive ETFs can provide low-cost, diversified exposure to broad-based markets, while an active approach can allocate capital to take advantage of growth opportunities that may outpace the broader market.

Yet implementing both effectively is often challenging for investors who run the risk of implementing these strategies in counterproductive ways. Among those risks is portfolio overconcentration, whereby an active strategy could lead to investing in securities already well represented in the passive sleeve of the portfolio.
That’s where an experienced investment advisor with a track record of working with both strategies can help investors devise a portfolio blending both to generate superior returns while mitigating risks.
In short, an advisor can help investors achieve the best of both worlds when it comes to growing their money.

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