Active vs. passive investment management strategies are often framed as opposing camps, with proponents championing their own approach while emphasizing the other’s drawbacks.
This has led many investors to believe the two are mutually exclusive; that choosing one means ruling out the other. However, both strategies can coexist in a portfolio to help reach investors’ financial goals.
Active Vs. Passive Investment Management | A Quick Comparison
Active investing is a hands-on approach that involves regular buying and selling of securities, focused on security selection, timing, sector tilts, and short-term price fluctuations. Passive investing is a buy-and-hold method, which includes limited buying and selling and thus results in lower fees.
Active investment enthusiasts contend that expert managers discover 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 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 investing advocates often cite research showing most active managers frequently fail to outperform their benchmarks. This leaves many investors feeling torn.
Let’s take a closer look at how these broad investment techniques can address different investor needs – even in the same portfolio.
Pros and Cons of Active Investing
Pros:
- An active strategy allows money managers to adjust their 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 (e.g. speculative technology stocks) and hold more defensive stocks (e.g. consumer staples).
- A tailored portfolio can bend around your actual life in a way a single index fund can’t. For example, a retiree who needs reliable, tax-aware income. The portfolio can be built to lean into that, weighting toward quality dividend payers, deciding where each holding sits across registered and non-registered accounts, and setting a drawdown order that keeps the tax bill sensible. A broad index like the S&P 500 wasn’t designed with any of that in mind. It’s a perfectly good building block, but it doesn’t know you’re retired or that you live in Alberta.
One thing worth being straight about though: that customization comes from thoughtful portfolio construction, and you can get a lot of it with low-cost passive tools too, so it isn’t the exclusive territory of active management. And more dividend income isn’t automatically a win. Dividends can provide a useful source of income, but in a taxable account, higher dividend distributions can also mean a higher annual tax bill, making them less tax-efficient in some circumstances than investments that generate more of their return through deferred capital gains. What you’re really after is the best total after-tax outcome, tuned to you. Not the highest headline yield.
Cons:
- Active management can be costly. Management fees, often referred to as management expense ratios (MERs) for mutual funds, are typically much higher than those of passive strategy funds.
For example, a Canadian equity mutual fund, run by an active manager, might charge an MER of 2% per year, whereas a passive exchange-traded fund (ETF), tracking the TSX Composite’s performance, may charge less than 0.1 percent per year. In addition, research shows that most active managers struggle to outperform their benchmark, often due to the higher fees they charge.
Pros and Cons of Passive Management
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 does not necessarily hold the best-performing securities on its benchmark index, leading to underperformance of the index. To that end, a 2023 S&P Global report 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, considering they generally involve less turnover of securities, and 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 can buy and hold a passive, broadly diversified ETF – a ‘set it and forget it 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 markets.
Cons:
- Passive strategies hold all of the market’s upside, but also all of 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 may be able to mitigate this risk, reducing exposure to this stock or sector.
- Passive approaches potentially limit returns in flat market conditions, whereas active managers can invest in faster-growing parts of the market while avoiding 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% of active managers outperformed their benchmark, the S&P 500.
A Hybrid Approach
A strong argument can be made for a hybrid approach. 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 investment strategies to generate returns while mitigating risks. In short, an advisor can help investors achieve the best of both worlds when it comes to growing their money.
Book a discovery call with Moraine Wealth today.
Disclaimer: This article is for informational and educational purposes only and does not constitute individual financial, investment, tax, or legal advice. Strategies mentioned may not be suitable for all investors. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. We recommend consulting with a qualified financial professional or tax advisor regarding your specific circumstances before making any financial decisions.