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Active vs Passive Investing

Actively-Managed and Passively-Managed Funds and Strategies

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What do people mean when they say "active" or "passive" in relation to investing strategies? Are actively-managed mutual funds better than passively-managed funds? Which performs the best in the long-term? What are the advantages of each? Is it a good idea to combine active and passive styles?

Active Investing Strategy Definition and Advantages

An active investing strategy is one that has an explicit or implicit objective of "beating the market." In simple terms, the word active means that an investor will try to pick investment securities that can outperform a broad market index, such as the S&P 500.

Portfolio managers of actively-managed mutual funds will have often have the same objective of outperforming a target benchmark. Investors buying these funds will ideally share the same goal of obtaining above-average returns.

The advantages for actively-managed funds are based upon the assumption that the portfolio manager can actively pick securities that will outperform a target benchmark. Because there is no requirement to hold the same securities as the benchmark index, it is assumed that the portfolio manager will buy or hold the securities that can outperform the index and avoid or sell those expected to under-perform.

Passive Investing Strategy Definition and Advantages

The passive investing strategy can be described by the idea that "if you can't beat 'em, join 'em." Active investing is in contrast to passive investing, which will often employ the use of index funds and ETFs, to match index performance, rather than beat it. Over time, the passive strategy often outperforms the active strategy. This largely due to the fact that active investing requires more time, financial resources, and market risk. As a result, expenses tend to pull down returns over time and the added risk increases the odds of losing to the target benchmark. Therefore, by virtue of not trying to beat the market, the investor lessens the risk of losing to it.

Because of this passive nature, index funds have low expense ratios and manager risk (poor performance due to various mistakes made by a fund manager) is removed. Therefore the primary advantage of passively-managed funds is that investors are assured that they will never under-perform the market.

Index Funds and Efficient Markets: Combining Active and Passive Investing

If you like the idea of investing in index funds but still want to tweak performance or find a wise but competitive edge as an investor, you may try combining the advantages of both indexing (passive investing) and active investing.

If you are familiar with the Efficient Market Hypothesis (EMH), you know that it essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. Therefore EMH says that investors cannot gain a competitive edge over the market without having inside information or a crystal ball.

But what if some information is not as widely known for some areas of the market as in other areas? Wouldn't this mean that some areas of the market are less "efficient" than others? If so, it would make sense to use an index fund for the efficient areas and actively-managed fund for the less efficient areas--the best of both worlds, if you will.

A good way to build a portfolio for the most advantageous way to combine the wisdom of indexing with active investing is to use one of the best S&P 500 Index funds for the large-cap stock allocation and actively-managed funds for the remaining portion. This is because there is much more information available on the larger companies that the majority of large-cap stock mutual fund managers fail to beat the best S&P 500 Index funds over long periods of time.

Consider 'Core and Satellite' Portfolio Design

For example, a good strategic model to follow is the Core and Satellite portfolio design where the index fund is the "core" at around 30 or 40% allocation and a combination of small-cap stock, foreign stock, a bond mutual fund and perhaps some sector funds to round out the portfolio. In this strategy, you'll satisfy your respect for the Efficient Market Hypothesis but also your alter ego that wants to stretch for some extra returns. Best of all you'll be able to stop changing large-cap stock funds every few years when they start losing to the S&P 500!

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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