Active vs. Passive Investing: Which Strategy Is Best?

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The debate over whether active or passive investing yields the best possibility of higher returns has gone on for many years. There are as many proponents of one perspective as there are of the other. But first, let’s understand the basic differences and similarities between the two styles.

As the name implies, active investing involves active trading in an effort to beat the return on well-known market indexes such as the S&P 500. Active traders evaluate each investment to find the ones with the greatest potential returns.
With passive investing, however, investors frequently choose investments such as mutual funds and exchange-traded funds (ETFs) that track a particular index. (The name also implies a long-term buy-and-hold philosophy that might not involve an index.) Passive investors aren’t trying to beat the market, they are trying to simply match its return.

Active vs. passive investing, compared

The table below outlines some of the basic differences between active and passive investing:

 Active investingPassive investing
Investment philosophyActive trading by selecting stocks (and bonds) with the potential to grow in value, in an effort to exceed the returns of well-known market indexes.Passive investing is a buy-and-hold philosophy that frequently mimics the holdings of popular market indexes.
CostCosts are relatively high because this philosophy is based on more frequent trading in an effort to improve returns. Management fees may also be higher.Costs are typically lower because trades are less frequent and less management is needed.
TransparencyTransparency is lower because the portfolio manager could buy virtually any security in an effort to improve return.Passive investing is more transparent because the fund or ETF typically only buys securities in a particular index.
TaxesIncome tax consequences of active investing are greater because more frequent trading could lead to taxable capital gains, which managers pass on to investors.For passive investors, potential tax consequences are often lower because trades are made less frequently, meaning there are fewer taxable gains to pass on.

Who might benefit from active investing?

For those who favor an active investment strategy, that support is largely based on confidence in the skills of portfolio managers, who investors believe can find opportunities with the potential to earn a higher return. While that support comes at a price in the form of higher expenses or fees, the argument is that those fees are worthwhile due to better performance.

Some argue that active investing works best for those with more money to invest; high-value investors could get better advice often at a lower rate. For instance, someone with $1 million to invest with a professional portfolio manager may pay a lower rate than someone who has $20,000 to invest in mutual funds.

Others argue that an active investment strategy works best in lesser-known portions of the market, where you need a portfolio manager’s expertise to identify potential winners and know when to sell those winners.

Many may find active investing to be a more flexible strategy, since active managers have the freedom to buy and sell virtually any security they think will benefit investors. Active managers can also use things like short sales, put options and other strategies to minimize losses. Finally, active managers can manage money to benefit the tax situation of individual investors and minimize capital gains.

The disadvantages of active investing are a mirror of its benefits. Experts argue that an active strategy is too expensive and the costs aren’t worth the benefits. Others may argue that the ability to buy any security reflects a lack of transparency, and that investors often don’t know what they’re investing in. Finally, sometimes it isn’t possible to perfectly manage tax consequences and you could be hit with an unplanned capital gain.

Some say passive investing is best

Passive or index-style investing has long been a popular strategy. Many investors are happy to simply duplicate the return of market indexes rather than try to beat them. Proponents argue that most portfolio managers don’t pick enough winners to justify the high fees they charge for active investing. After all, no one gets things right 100% of the time.

Mega-investor Warren Buffett is one who believes that a passive style of investing can pay off. As reported by CNBC, he suggests passive investing is a sensible way to increase savings for retirement. According to Buffett, index funds are inexpensive and their performance isn’t tied to the success of a single company.

Passive investing has several factors that make it attractive to casual investors, including relatively low fees (since there is no need to pay anyone to analyze investments), appropriate transparency (since investors know what stocks or bonds make up a particular index), and tax efficiency (since most indexes have a buy-and-hold philosophy and there are typically fewer trades to trigger capital gains).

Of course, there are some disadvantages to passive investing as well. One of the biggest is a lack of flexibility. Even if the manager of an index fund knows a particular stock price is about to decline, the fund likely prohibits taking so-called defensive measures, including outright selling the stock.

Bottom line

Ultimately, the choice between active and passive depends on the individual investor. Not just on which strategy they think suits them best, but also on factors such as the time horizon of the investment, their sensitivity to cost and their tax situation. As with most investments, it’s all about your needs and goals.

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