Active and passive portfolio management styles are two contrasting investing strategies. One involves active participation and management of the portfolio while the other requires fewer movements.
Let us discuss what active and passive portfolio management styles are and what are the key differences between them.
What is Active Portfolio Management?
Active portfolio management refers to an investing style where the portfolio manager actively makes investing decisions.
Active managers rely on analytics, technical indicators, personal judgments, and market forecasts to make these active investing decisions.
This type of investing style requires buying, selling, and holding financial assets in a portfolio. Active decisions mean the portfolio consistently changes.
Active portfolios also follow an index as a benchmark and mimic their portfolio assets. However, active investing aims to beat the index rate of return by changing the portfolio balance consistently.
Active managers utilize quantitative and qualitative tools to achieve their required rate of return. Some active portfolios also target additional goals like managing financial risks, lowering tax burden, or following certain investing standards.
How Does Active Portfolio Management Work?
Active portfolio managers contradict the Efficient Market Hypothesis (EMH). They believe a perfectly efficient market does not exist and hence investors can beat the market in the long run.
The EMH argues that all publicly available information already reflects in the stock prices and hence investors cannot outperform the market in the long term.
Active portfolio management first sets the objectives of the portfolio. It then sets a benchmark rate of return and a time horizon.
The planning stage may include portfolio risk and reward goals, asset selection, rebalancing guidelines, and communication rules for the fund.
Then, the portfolio manager will select asset classes and assign the weightage to each one to construct the fund.
The execution stage then includes rebalancing the portfolio and adjusting the asset weightage as and when needed.
As mentioned, active portfolio management involves constant feedback. This step involves constantly rebalancing the fund to keep the required rate of return on track.
Benefits of Active Portfolio Management
Active portfolio management comes with some discrete benefits:
- Active portfolio utilizes the experience, skills, and personal judgment of portfolio managers.
- Active management offers more flexibility to investment managers.
- This management style believes they can achieve higher returns than passive investing.
- It allows benefiting from volatile markets which is hard to achieve with a passive investing style.
Limitations of Active Portfolio Management
Active portfolio management also comes with some disadvantages:
- There is no hard evidence of active investing outperforming passive investing in the long run.
- The portfolio management and results directly depend on the manager’s performance and exposure.
- Bad investment decisions can result in lower returns than those achieved by passive investors for the same tenure.
- It involves taking higher risks as compared to passive investing.
- Investors may not control portfolio management as they set up higher return-reward goals.
- Active management is expensive as it requires more staff and resources.
- It is difficult to achieve diversification as the investment portfolio grows and hence it starts producing results like a passively managed portfolio in the long term.
What is Passive Portfolio Management?
Passive portfolio management refers to an investment strategy where investors aim to achieve returns of an index or a benchmark.
It is also called index investing as it follows a market index. The primary objective of passive investing is to mimic the investing strategy of an index.
Thus, a passive portfolio manager usually does not require extensive tools and research. The job is to construct a similar portfolio to its target index and follow the changes the index makes.
The idea behind the passive investing style is to buy cheap and sell higher by holding financial securities for a longer period. It follows the common notion of the market appreciating in the long run.
How Does Passive Portfolio Management Work?
The principle behind passive portfolio management is that investors cannot beat the market in the long term. It’s simply in line with EMH theory.
Investors set eyes on a benchmark index like S&P 500, NASDAQ 100, or Russel 1000. Since each index comes with diversification naturally, the portfolio will be diversified as well.
Creating exactly the same basket of securities as an index is impossible though. So, the investment managers construct a similar portfolio with the same asset class weightings.
The other option is to create the same portfolio with a much smaller size of investments. Either way, the objective is to match the risk and reward structure of the index.
Then, the key feature of passive investing is to maintain a consistent basket of securities for a longer period. It simply follows the buy-and-hold investing formula.
As the market appreciates generally, the portfolio appreciates as well, and vice versa.
Benefits of Passive Portfolio Management
Some key benefits of passive portfolio management include:
- It’s easier for investors to follow passive investing as indices are visible to everyone publicly.
- This investing style comes with significantly lower risks as compared to active investing.
- It aims to reduce transaction costs and management expenses substantially. Hence, it achieves lower expense ratios.
- Passive investing follows an index that comes naturally diversified.
- Historic market analysis has shown that passive portfolios achieve higher returns than actively managed portfolios.
Limitations of Passive Portfolio Management
Passive portfolio management also comes with some limitations:
- Passive investing is only suitable for investors looking for long-term gains. It hardly produces good returns in the short term.
- Passive investing cannot take advantage of short-term market volatility. Also, it hardly achieves good returns in market downturns and economic recessions.
- Investors only achieve a rate of return as an index achieves at best. It means passive investing will hardly beat the market returns realistically.
- Investors follow one index at a time. So, their performance will directly depend on the performance of the index itself.
Active Vs. Passive Portfolio Management – Which One is Better?
Investors can choose between the two contrasting portfolio management styles. Both styles contradict each other in the way they’re constructed and managed.
The right option will depend largely on the investment objectives of the investors and their expectations from the portfolio manager. Both sets of managers can achieve their required results when managed well.
Active investing is a good choice for risk-takers. If investors have a higher risk tolerance and they want to achieve a higher rate of return than the market, active investing is their option.
Contrarily, if investors want a sustainable investment portfolio in the long run, they should go with the passive investing style. It will yield equally good returns in the long term as active investing will in the short term.
Combining Active and Passive Portfolio Management Strategies
A newer strategy for portfolio managers in recent years has been to combine both active and passive portfolio management styles.
For example, if the market is going through volatility and economic turmoil, active investing can yield higher returns when planned well.
Similarly, if market indices and certain sectors have established trends, it’s better to devise passive investing.
At the same time, portfolio managers can pick certain sectors or asset classes to invest in during different market conditions. Thus, taking a hybrid approach can reduce risk, lower costs, and still achieve better returns than the average market rate.