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Passive vs. Active Portfolio Management: An Overview
Investors have two main investment strategies that can be used to generate a return on their investment accounts: active portfolio management and passive portfolio management. As the names imply, active portfolio management usually involves more frequent trades than passive management.
Active portfolio management strives to outperform the market in comparison to a specific benchmark such as the Standard & Poor’s 500 Index.
Passive portfolio management mimics the investment holdings of a specific benchmark to achieve similar results.
Some investors manage their own money while others hire a portfolio manager to do the work. Others invest primarily in actively managed or passively managed mutual funds or exchange-traded funds (ETFs).
Key Takeaways
- Active management requires aims to exceed the performance of a market index or other benchmark.
- Passive management replicates an index or other benchmark to match its performance.
- Active management portfolios strive for superior returns but take greater risks and involve larger fees.
Active Portfolio Management
The investor who follows an active portfolio management strategy buys and sells stocks in an attempt to outperform an index such as the Standard & Poor’s 500 or the Russell 1000 Index.
An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers all making investment decisions for the fund. The success of the fund depends on in-depth research, market forecasting, and the expertise of the management team.
Portfolio managers engaged in active investing follow market trends, shifts in the economy, changes to the political landscape, and any other factors that may affect specific companies. This data is used to time the purchase or sale of assets.
Proponents of active management claim that these processes can result in higher returns than can be achieved by simply mimicking the stocks listed on an index.
Since the objective of a portfolio manager in an actively managed fund is to beat the market, this strategy requires taking on greater market risk than is required for passive portfolio management.
Passive portfolio management is also known as index fund management.
Passive Portfolio Management
Passive portfolio management can be called index fund management. A passive portfolio manager buys only the stocks that are listed on an index and sells shares only when the stock is removed from the index or its weighting in the index is reduced.
This is because a passive portfolio is typically designed to parallel the returns of a particular market index or benchmark as closely as possible. Each stock listed on an index is weighted. That is, it represents a percentage of the index that is commensurate with its size and influence in the real world. The creator of an index portfolio will use the same weights.
The purpose of passive portfolio management is to generate a return that is the same as the chosen index.
A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust (UIT).
Index funds are branded as passively managed rather than unmanaged because each has a portfolio manager who is in charge of replicating the index. Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.
Index mutual funds and ETFs are easy to understand and offer a less risky approach to investing in broad segments of the market.
Could I Create My Own Passively Managed Stock Fund?
Probably, but it would take a massive cash outlay and a lot of work to create and maintain your portfolio. For example, if you were creating a portfolio that mimics the performance of the S&P 500, you’d have to buy some shares of all 500 of those stocks. The index is weighted, so you would have to buy the stocks in the same percentage as they are represented in the index. The components and their weightings are revised periodically, so you’d have to revise your holdings accordingly.
This is why index funds exist. Passively managed mutual funds and ETFs use their investors’ money to create and maintain a fund that parallels an index.
How Can I Diversify My Passively Managed Portfolio?
There is a huge range of passively-managed funds to choose from. The top three in sheer size are S&P 500 Index funds, but there are many others that parallel major benchmarks in industries such as technology and pharmaceuticals. Others focus on bonds, gold, or global investing. A thoughtful selection of these will get you a diversified portfolio.
Why Would I Choose an Actively Managed Fund?
Actively managed funds have a stated goal of outperforming a benchmark such as the S&P 500 Index. Some do and others don’t.
That said, in 2023, the five best-performing mutual funds logged returns above 50% for their investors, mostly due to heavy investment in the “Magnificent 7” technology stocks. The S&P 500 rose 24.23% over the year.
The Bottom Line
One of the first questions you have to ask yourself as an investor is this: Do I want to take an active approach or a passive approach to investing?
The active approach takes a lot more work, either by you or by someone you hire to manage your money. It means higher fees. And it holds out the possibility (but not the promise) of higher returns.
The passive approach sets a goal of matching the performance of a standard benchmark for the overall market or some sector of it. Your profits depend on the direction of the index. There are no further decisions to be made.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.
