Active vs. Passive: The Basics

Active management is simply an attempt to "beat" the market as measured by a particular benchmark or index. The aim of active fund management — after fees are paid — is to outperform the index for a particular fund (not to mention other fund managers they may be competing against).

Passive management is more commonly called indexing. Indexing is an investment management approach based on investing in exactly the same securities, in the same proportions, as an index. The management style is considered passive because portfolio managers don't make decisions about which securities to buy and sell; they simply copy the index by purchasing the same securities included in a particular stock or bond market index.

Which Approach Works Best?

That's a never-ending debate. Hard facts aside, active and passive management are in many ways similar to political parties. The two camps see the investment world in very different ways, both making logical and passionate arguments for their viewpoint.

Indexers generally believe that it is difficult to beat the market. Therefore, they essentially offer asset class performance that closely matches an index for those investors who are unwilling to assume the risks of active management.

Active managers believe the market can be beaten. While they can't beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.

The Active Approach:

Active Management Advantages Active Management Disadvantages

Expert analysis — Seasoned money managers make informed decisions based on experience, judgment, and prevailing market trends.

Possibility of higher-than-index returns — Managers aim to beat the performance of the index.

Defensive measures — Managers can make changes if they believe the market may take a downturn.

Higher fees and operating expenses. Mistakes may happen — There is always the

risk that managers may make unwise choices on behalf of investors, which could reduce returns.

Style issues may interfere with performance — At any given time, a manager's style may be in or out of favor with the market, which could reduce returns.

The Passive Approach:

Passive Management Advantages Passive Management Disadvantages

Low operating expenses. No action required — There is no decision-

making required by the manager or the investor.

Performance dictated by index — Investors must be satisfied with market returns because that is the best any index fund can do.

Lack of control — Managers cannot take action. Index fund managers are usually prohibited from using defensive measures,

such as moving out of stocks, if the manager thinks stock prices are going to decline.

Taking a Long-Term View

The investment community will continue to debate the benefits of active versus passive investment management. And from time to time, one approach will be more popular than the other. Within the equities arena, in particular, the passive managers have done well over the last decade but the trends maybe changing as the secular bull market of the late 20th century is over. During challenging sideways markets the active manager at least has an opportunity to take action, which puts the passive manager at a distinct disadvantage. Take for example the secular bear market of 1966 - 1982, which generated a negative (1.18%) compounded annual rate of return over 16.5 years. That's a long time of sub par performance that the passive managers conveniently hide when they preach about their long-term trading performance.

Within the alternative investment arena the differences between passive and active managers are even more pronounced. The bullish bias of equities are not typically seen on the cyclical nature of commodities. Certainly over short periods passive managers can do well, especially if their portfolios are heavily weighted in explosive markets. But for the most part and over a longer time period the active manager should out perform the passive managers for the simple reason they can react to changing environments while passive managers are really only there for the ride.