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Active vs. Passive Investing
Understanding the Difference in Styles
It's easy to get caught up in the Bay Street hype about which investment approach is better. Proponents of each seem to believe their approach is the right one, the one that has the potential to generate the greatest amount of return over the long term.
Active vs. Passive: The Basics
Active management is simply an attempt to "beat" the market as measured by a particular benchmark or index. The Standard & Poor's Corp. (S&P) 500 Index and the Russell 1000® are examples of two indexes that gauge the performance of the large cap US stock market — the so-called "blue chip" stocks. In Canada, the broad market is generally measured by the TSE 300 Index. This index measures the performance of the 300 largest companies by market capitalization in the country.
Frank Russell Company subscribes to the active management approach.
Prevailing market trends, the economy, political and other current events, and company-specific factors (such as earnings growth) all affect an active manager's decisions. The aim of active fund management — after fees are paid — is to outperform the index for a particular fund (not to mention other fund managers they may be competing against).
Passive management is more commonly called indexing. Indexing is an investment management approach based on investing in exactly the same securities, in the same proportions, as an index such as the S&P 500 or the TSE 300.
The management style is considered passive because portfolio managers don't make decisions about which securities to buy and sell; they simply copy the index by purchasing the same securities included in a particular stock or bond market index, of the same weights.
Which Approach Works Best?
That's a never-ending debate. Hard facts aside, active and passive management are in many ways similar to political parties. The two camps see the investment world in very different ways, both making logical and passionate arguments for their viewpoint.
Indexers generally believe that it is difficult to beat the market. Therefore, they essentially offer asset class performance that is guaranteed to match an index for those investors who are unwilling to assume the risks of active management.
Active managers believe the market can be beaten. While they can't beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns with minimum additional risk.
"Indexing should be viewed as a low-cost way to replicate the performance of a particular asset class," says Paul Greenwood, a senior research analyst in Russell's Investment Policy and Research Group. "However, active management offers the potential to do even better, although there is no guarantee of superior performance. The trick is to have the ability to identify which active managers are the best."
Advantages and Disadvantages
Advantages
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- Expert analysis. Seasoned managers make informed decisions based on experience, judgement, and prevailing market trends.
- Possibility of higher-than-index returns. Managers aim to beat the performance of the index, which means they strive for higher returns than the index delivers.
- Defensive measures. Managers can make changes if they believe the market may take a downturn.
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Disadvantages
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- Higher fees and operating expenses.
- Mistakes may happen. There is always the risk that managers may make unwise choices on behalf of investors, which could reduce returns.
- Style issues may interfere with performance. At any given time, a manager's style may be in or out of favour with the market, which could reduce returns.
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Passive Management
Advantages
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- Low operating expenses.
- Market performance. Investors can be assured that index funds will perform on par with the indexes.
- No action required. There is no decision-making required by the manager or the investor.
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Disadvantages
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- Performance dictated by index. Investors must be satisfied with market returns because that is the best any index fund can do.
- Lack of control. Managers cannot take action. Index fund managers are usually prohibited from using defensive measures, such as moving out of stocks, if the manager thinks stock prices are going to decline.
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Taking a Long-Term View
Investment professionals will continue to debate the benefits of active versus passive investment management. And from time to time, one style will be more popular than the other.
As an individual investor, try to ignore the water cooler gossip and the "trend of the moment." When all is said and done, keep in mind that both active and passive managers are selecting investments from the same pool of equities.
"In times when market leadership is narrowly concentrated in large stocks — like it has been since early 1994 — active management is hard-pressed to keep pace with passive," says Greenwood. "In the early '90s, small cap stocks were performing much better than large, and active managers prospered. As the investing environment changes, we will continue to see active and passive management go in and out of favour."
Nothing contained in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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