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Key Differences Between Active vs. Passive Investing

There’s a debate raging in the finance and investing arena, right now, about which method of money management is better:  Active or Passive Investing? Investors, lately, have favored passive investing.  Portfolio managers, those whose compensation is directly tied to how much money they manage and the return they deliver to investors, tend to favor active management.  Surprising, right?  But before we send portfolio managers the way of the dinosaur and dodo bird, let’s look at this topic a little more closely.

Active Investing Defined

Active investing, once known as regular ol’ investing once-upon-a-time, involves a portfolio manager.  Their job is to pick the right investments to generate (hopefully) outsized returns, to justify their job.  After all, if someone’s not making you money, in the long-run, why have them around?  As the name implies, they’re actively managing a portfolio of investments, moving in and out of different ones.  The active investment everyone’s heard of are mutual funds.   All this activity comes with costs:  buying and selling commissions, transaction costs, overhead, and salaries.  Nobody’s right all the time, so they have to be right more often than they’re wrong.

Passive Investing Defined

Passive investing is basically the opposite of active investing.  The primary vehicles for passive investing are index funds and ETF’s.  Index funds follow an index.  It could be the Dow Jones, S&P 500, NASDAQ, any sector, a country – anything.  Keep in mind that you don’t actually own the investments that the index tracks.  For example, if you bought an S&P 500 index fund, the value of your investment track the S&P 500.  You don’t actually own shares of company’s that comprise the S&P 500.  ETF’s (Exchange Traded Funds) are the skim-milk version of mutual funds.  You do indirectly own the shares in the ETF but unlike a mutual fund, you don’t have to wait until the end of the trading day to know what each ETF share is priced at.  They trade on an exchange just like a share of stock.

There’s been an explosion in recent years in the popularity of both.  One of the main reasons are the expense ratios.  It’s cheaper to own (on average) an index fund or an ETF than a mutual fund.

Benefits of Active Investing

An important benefit of active investing is found in risk management. An active manager can move in and out of investments to align with prevailing market conditions. This permits an investor with the ability to make broad adjustments to better ensure longer-term investment success. In addition, it permits the ability to take advantage of short-term price movements that are only accessible via an active investing strategy.

Active Investing can be more tax-efficient.  Many managers will sell off investments at a loss to offset gains, boosting (hopefully) after-tax returns.  Active managers can also hedge their investments using options, futures and other derivatives.

Limitations of Active Investing

There are some limiting aspects associated with active investing. Active investing can be a costly endeavor in some instances. In addition to the costs discussed above with mutual funds, there are more if you decide (and can afford) to invest in hedge funds. On top of the (usual) 2% management fee you’ll pay for them to manage your money, you’ll also pay a ‘performance fee’.  Meaning, any gains they generate, they’ll keep up to 20%.  Expensive, indeed.

Some mutual funds also have a minimum amount to invest – not so with index funds and ETF’s.

Benefits of Passive Investing

Passive investments avoid many of the types of fees and costs associated with active investments. As a passive investor, you don’t have cut checks to pay commissions or salaries.

Passive investing is also great for investors that don’t have the time or interest to do their own research.  If you own an S&P 500 index fund, for example, knowing whether it’s up or down is enough.  You’re not burdened with picking stocks that you think will do well.  Buy-and-hold is the order of the day for passive investors. 

Though not a part of the traditional passive investing arena, real estate can be held as a passive investment. For example, a person can buy and hold real estate with an eye towards selling it down the road.

As an aside, real estate can also become an active investment. This is the case when the owner actively participates in the management of the property.

Limitations of Passive Investing

While tracking an index may be easy it’s also fairly limiting.  Once you own it, there won’t be much difference in your holdings.  You may miss out on some short-term opportunities.  Since most passive investments track an index, ‘beating the market’ isn’t something you’ll do. Even passive comes with a cost and it isn’t always measured in dollars and cents.

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