The Benefits and Drawbacks of Passive vs. Active Investment Strategies

The Pros and Cons of Active and Passive Investments

The active investors that I know take risks. Their portfolio managers seek high returns by picking big winners to beat the market index—the market's overall performance. Active investors can reap huge returns and windfall profits, but precise timing is critical in decision-making and there are no guarantees.

Passive investors, on the other hand, are more risk-averse and build portfolios whose profits may be no better or worse than the index they mirror. They simply share in the market's long-term ups and downs. They accept the indexes they follow—the S&P 500, NYSE Composite, or NASDAQ, for example—as their benchmark for profit.

The Passive Side

When I advise clients to adopt a passive investment strategy in their portfolios, I typically favor mutual funds, exchange-traded funds (ETFs), and the like to match the returns made by the market index that we agree to follow. Those funds usually all hold similar securities, sometimes hundreds of them. If I were acting as their manager, I would follow a buy-and-hold strategy, allowing me to avoid active decisions, trade less often, make fewer capital-gain taxable transactions, and therefore charge a lower fee—for passive strategy fund managers, typically as low as 0.2% to 0.1% or lower.

However, I've also seen the downside of a passive strategy. In the 1990s, for example, we watched the Financial Times Stock Exchange 100 Index (FTSE 100) become the index of choice for technology and telecom stock investors who "rode the index wave" quite profitably. Unfortunately, the later, storied decline in that market led to spectacular losses for investors who stayed on-board too long. This also illustrates the risk of over-concentration in only a few stocks or sectors, especially in a passively watched index.

As a result, I advise my clients to protect their passive investment strategy with ongoing vigilance. Otherwise, passive investments can become complacent and suffer serious losses. With the right care, however, passive investors will profit from the power of compounding—achieving exponential growth—that reliably builds their asset values over time, along with their market index. Some investors believe that the risks in passive management are so low that individuals can manage their portfolio alone.

The Active Side

The job of an active investment manager is simply to outperform the index and achieve higher returns. In these cases, I strongly advise constant analysis of the market, sector, or shares and equities in which my client invests. It is also one of the reasons that active investment managers charge higher fees, often in the 1% to 3% range.

An active investment manager can outperform the market index by picking winners, diamonds-in-the-rough, based on research and knowing both history and trends. However, I assure my clients that an active investment strategy is not a gamble. It relies on acting deliberately, and sometimes quickly, on making an educated forecast of high growth and profit potential. This strategy is best suited to an investor who is well-seasoned in the economic factors that create and move asset values.

One active strategy some of us employ is to invest in undervalued assets that have unrecognized potential for strong growth and high profits. This is a buy-sell strategy sometimes dubbed "stock-picking." Our goal is to profit from a higher selling price on resale or to earn higher dividends over time. Active investment managers also apply a "hedging" strategy, the use of short sales, put options, and other loss-sparing tactics.

An active investment strategy also relies on an investor's ability to limit the downside inherent in fast-moving changes of asset value or market index. Whether it is a one-time industry disruption, a rare-time macroeconomic force like Covid-19, or a shift in international relations, an alert active investor can adapt, buy, sell, or shift assets before sudden shifts become trends. This advantage also comes into play in a sudden profit opportunity.

On the other hand, I have found that rapid buy-and-sell activity is typically less tax-efficient than a passive investment strategy. Some trends and events, if unrecognized soon enough, can lead to underperforming the market index.

The Balance

I, and many other seasoned investors, have had to develop a finely-tuned knack for balancing passive against active investment strategies through research, training, and extensive financial market experience. My key word in that sentence is “balanced.”

In every way possible, I combine both passive and active techniques in a well balanced portfolio. I find it critical, however, to vary the proportion of passive vs active strategy by keeping a sharp eye out for changes and by keeping my client’s investment goals current.

I have seen, and most market-watchers agree, that passively managed funds outperform actively managed funds most of the time as compared to the index over a 10-year period. Market researchers, such as those at the Wharton School, caution that in many cases, “active investment managers are not able to pick enough winners to justify their high fees.” * Yet, I have seen a few active investment managers who have reversed those odds on occasion by creating bespoke portfolios focused on a specific, narrowly defined index.

Investors with large portfolios and high asset value often set aside a portion of their assets for active management. In this way, they can confine losses that may occur to only one sector, leaving their overall finances intact. These high net worth investors may also have investment options unavailable to small investors. For those smaller investors, and for all others in challenging times, I advise applying the more passive strategies for a more likely profitable outcome.

My key advice for investors, then, is to pay constant attention to the proportion--not necessarily the presence or absence--of passive and active investment strategies, along with careful timing and adjustable risk tolerance.

About Robert Wickboldt III

Robert Wickboldt III, founder and CEO at Essex Investments headquartered in Reno, NV, is a busy professional whose active lifestyle also captures the essence of both active and passive investment outlooks.

*https://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns/

This article does not necessarily reflect the opinions of the editors or management of EconoTimes