January 05, 2018
Google the phrase “active vs. passive investing,” and you’ll get some 64,000 hits, demonstrating that this is a two-sided debate with many vocal participants. “But it’s a mistake to view either approach as inherently superior to the other,” says John De Clue, Chief Investment Officer for U.S. Bank Private Wealth Management. “The reality is that most investors can be well-served by a combination of active and passive strategies.”
As the term suggests, active investing relies on the skills and judgment of a portfolio manager who seeks to outperform the market by choosing investments matched to the client’s objectives, moving in and out of positions to take advantage of pricing inefficiencies. In contrast, a passive strategy aims to duplicate the returns of an index, such as the Standard & Poor’s 500 or the NASDAQ Composite, by mirroring its holdings and not including any independent buy or sell decisions.
While active and passive strategies each have their advantages, investors have been fleeing active managers in droves over the past decade. According to Morningstar, investors pulled more than $285 billion from actively managed U.S. equity mutual funds in 2016 and sent more than $428 billion flowing into passive stock funds, including index funds and exchange-traded funds (ETFs). ETFs are marketable securities that track an index, index fund, commodity or bond and trade like common stocks on a stock exchange.
The pros and cons of passive investing
“The case for passive investing is fairly straightforward and derives from the overall efficiency of the market — meaning that the prices of most securities will reflect their actual value and that the same information is available to all investors,” says Peter Braude, Research Analyst for U.S. Bank Wealth Management. “That makes outperforming difficult.”
A passive strategy is designed to meet — not beat — the performance of its benchmark, potentially reducing the risk of underperforming the market. It’s a simpler way of investing, with no opportunity for market timing, stock selection or other human intervention. Because any changes in the underlying index will be automatically replicated in an index fund, the returns will ideally track those of the index.
There are other differences as well — such as greater transparency and lower fees. “ETFs are totally transparent — you can see exactly what’s in them at all times, and you can buy and sell them throughout the trading day like stocks,” Braude says. Transaction fees, management expenses and capital gains taxes are significantly lower than those for actively traded accounts. And, unlike mutual funds, which are typically re-priced just once a day, ETF prices are updated constantly, so you always know their exact value.
At the same time, passive investing also comes with caveats. “ETFs are not risk-free investments,” De Clue says. “For one thing, you’re exposed to the risk of the underlying securities, which can be exacerbated by market or political instability.”