Passive vs Active Management: Merits and Considerations

Passive management and active management are the two prevailing types of investment management. Passive management primarily tracks an index whereas active management involves actively trying to beat an index or benchmark.

Passive Management

Proponents of passive management subscribe to the semi-strong and strong forms of the Efficient Market Hypothesis, i.e. it's impossible to consistently beat the market over the long-term. Since it's impossible to beat the market, investors are better off by using low-cost, passive strategies.

The idea behind passive investing is to track an index (or multiple indices) of stocks, such as the S&P 500. The easiest way to do this is to buy passive funds, such as ETFs and/or mutual funds. In doing so, investors are able to diversify away unsystematic risk. In other words, their portfolios become less affected by the movements of individual stocks, and, instead, investors generate returns by participating in the general growth of corporate earnings over time.

Passive investing certainly has its merits. A study done by Morningstar found that only 23% of active managers were able to outperform their passive peers over a 10-year period starting in June 2009. This means that the majority of investors can and should use passive strategies because they will not be able to consistently beat the market through active strategies.

Active Management

Proponents of active management believe that the markets can be beat through more hands-on strategies. Active managers typically use sophisticated strategies (including tactical trading, hedging, shorting, and leverage) in an attempt to outperform an index.

Tactical trading involves timing trades to the market. In other words, investors are trying to "buy low and sell high." Investors will often also reallocate money from overbought stocks to ones that they consider oversold. Tactical trading has many potential benefits, but also a high degree of risk if the investor's timing is wrong.

Hedging involves making an investment that is designed to reduce the risk of another investment. For example, an investor might buy a put option designed to hedge against losses in the long stock position. There are many ways to hedge, but shorting is one of the most common ways to do so.

Shorting (or short-selling) is when an investor bets that a stock will decline in value. The process involves an investor borrowing a stock from a broker, selling that stock on the open market, then buying it back to return to the broker at a later point in time. Here, the investor will benefit if the stock declines in value. Active managers will often use shorting to hedge their portfolio and also to bet that stocks and/or the market will decline.

Leverage (or margin) is when an investor borrows money to buy/sell stocks. Leverage can be very rewarding but also very dangerous because it amplifies the movements of an investor's portfolio, whether up or down.

So What?

So what does all of this mean for you? Should you go with passive management or active management? Well, the answer is not that simple. Most investors would benefit from a bit of both.

Passive management is by far the most popular type of management by AUM. Passive managers have also largely outperformed active managers. Passive management has several benefits, including low fees, low taxes (due to a low amount of trades), and simplicity. On the other hand, passive management is not without its faults either. Passive strategies rarely, if ever, outperform the market on both an absolute and risk-adjusted basis. Passive strategies also result in large drawdowns during periods of market weakness (e.g. 2008 recession, COVID-19).

Active management is much harder to get right than passive management. If you are interested in active management, it's very important to identify which managers will be able to consistently beat the market. Active managers will typically charge significantly higher fees than their passive counterparts because there is much more work involved. Active strategies also commonly generate higher taxes than passive strategies because of the larger amount of trades being made. However, these additional expenses are worth it if the manager is good. Top managers are able to outperform the market, generate consistent, risk-adjusted returns across all market environments, and limit drawdowns during bad years.

Just like anything else in life, it's best not to put all your eggs in one basket. Investors should seek to diversify their portfolios as much as possible. You've heard about diversifying your holdings, but you can and should also diversify your strategies. This is why you should use a mix of both passive management and active management.