As soon as one investment strategy appears to have taken the upper hand, market conditions shift and performance trends reverse themselves. Due to this cyclical nature of both active and passive strategies, it’s essential that investors stay committed to long-term goals.
This insight focuses on the Morningstar Large Blend category; however, its pattern can be observed across other categories as well.
Performance
Passive investing is an effortless form of investing, requiring less research, monitoring and trading fees compared to its counterpart. Passive investments allow investors to focus more on enjoying life than worrying about returns over time.
Passively managed index funds such as exchange-traded funds (ETFs) track the performance of an index in either stocks or bonds, meaning they don’t incur individual company volatility but still experience total market risks.
Active investments rely on fund managers’ abilities to buy and sell stocks based on research, analysis and market insights. Unfortunately, frequent buying can increase fund management costs significantly as well as limit performance returns over the long term. Research demonstrates few actively managed funds deliver returns superior to benchmarks over extended periods.
Risk
Passive strategies follow a broad market index or sector and typically offer low fees, stability and effective risk management. They can be an excellent option for individuals with shorter investment horizons who place more importance on predictability than potential growth.
Active managers strive to surpass benchmarks by researching, analyzing, and making buy/sell decisions based on research. While many fail at outperforming the market overall, some do manage it successfully during down markets when stocks may not move together as predictably and thus provide active managers an edge.
Passive funds provide greater transparency, lower fees and are tax efficient as their buy-and-hold strategy rarely triggers large capital gains taxes each year. Unfortunately, passive funds may only cover one index and do not offer active management’s potential to outshout in either up or sideways markets.
Fees
Passive investment approaches rely on index funds and ETFs to reduce risk by diversifying across hundreds of individual stocks – potentially yielding lower costs with greater stability and the potential to build wealth gradually with reduced volatility.
Active investing involves keeping an eye on market trends and making changes to your portfolio that could yield above-market returns, but research indicates it’s difficult to consistently outstrip market average returns when considering fees and costs.
Longer term, passive bond mutual funds and ETFs tend to outshone their actively managed counterparts after fees, although active management could still be advantageous in certain asset classes and portions of the market such as stocks of small U.S. companies.
Taxes
Passive strategies provide investors with both ultra-low fees and tax efficiency. Fewer transactions mean less taxable events such as capital gains that could add up over time and benefit retirement accounts more directly.
Passive investing may limit investment choices as funds tend to follow the performance of the market and won’t significantly outstrip it unless overall stock prices increase dramatically. Furthermore, passive investments don’t allow for the thrill of watching one stock skyrocket in value.
Studies have demonstrated that active strategies perform better in specific investing climates, like down markets. But they may underperform in neutral or bull markets. If you’re still undecided which strategy best fits your goals, why not combine both passive and active approaches into one hybrid strategy?
Blending
Many investors utilize both active and passive strategies in order to reap their full advantages. Passive investing typically comes with lower fees, easier portfolio construction and allows tracking performance of individual markets or indexes more readily.
Active management on the other hand offers greater agility during volatile market conditions by conducting value-based research and drawing upon industry expertise. Furthermore, this strategy may help prevent costly errors when responding to sudden market shifts by anticipating their movements ahead of time and reacting appropriately.
As interest rates rise, active managers may find it more challenging to outpace their benchmarks. Therefore, investors may benefit from opting for passive investment vehicles that feature low fees, transparency and tax efficiency for most of their holdings.