Breaking Down Passive and Active Investing

Breaking Down Passive and Active Investing

As a consumer, you want to feel confident in the choices you make. When it comes to investing, it’s important to understand your options. Investing, like other technical industries, has no shortfall of jargon and buzzwords. So let’s dive into the concept of “passive” and “active” investing to help break down the differences between the two approaches.

Passive strategies are designed to mimic market indices, while active management seeks to benefit from mispriced assets in capital markets—stocks, bonds, commodities, currencies, etc.

One Product, Many Holdings

Whether you purchase shares in a mutual fund that uses a passive or active approach, you invest in multiple securities at once. Either strategy provides a convenient way to gain broader exposure than you would by purchasing securities individually. Depending on the type of fund, you can get exposure to specific investment categories among stocks, bonds or other investment types. Keep in mind fees will vary between passive and active managers.

Mirror vs. Magnifying Glass

In a passive portfolio, managers purchase securities based on what’s in a given index. For example, a passive fund tracking the S&P 500® Index would mirror the stocks currently present in that index. The managers buy those positions but make no other adjustments to the portfolio.

In an active portfolio, managers may use an index to benchmark performance, but it doesn’t dictate which stocks they purchase. Active portfolio managers put company and market information under a magnifying glass. They’re searching for the winners of tomorrow whose return potential is not yet reflected in their current stock prices.

Passengers vs. Drivers

In a passive portfolio, managers only buy if that security is in the index. The opposite is also true; securities are sold only if they are no longer in the index. No judgment is involved around whether to buy or sell. Passive managers take a back seat, letting the index drive the portfolio.

In an active portfolio, the managers’ job is to distinguish between attractive and unattractive investment opportunities. They do this in different ways; some active managers perform bottom-up fundamental research and monitor individual companies. Others may leverage top-down economic and industry-specific knowledge. Regardless of their approach, active managers drive decisions around what their portfolios hold.

It’s important to note that not all active managers are the same. You should consider a manager’s tenure and experience in your selection process, because not all will have the same ability to compete with a passive index.

Tracking the World that Was

To see how passive and active approaches come into play, consider two of the largest stock market downturns of the last 19 years. The chart below tracks the S&P 500 Index sector weightings since 1997. Imagine holding a significant weight of technology stocks when the tech bubble burst, or being loaded with financial stocks during the financial crisis. In both situations, an active manager would have the opportunity to make changes to the portfolio—a passive manager would not.

Passive Investing: Tracking the World that Was

The sting from these downturns reminds us that corrections are a normal part of the market cycle. The ability of an active manager to respond to and navigate the market’s ups and downs is a valuable consideration in a challenging investment climate, like the one we’re in today. Slow growth, modest returns and the probability of heightened risks going forward define the current market; identifying an active manager with a unique process, attractive risk profile and competitive track record is key.

As a core investing belief, an active approach is a critical element shaping the philosophy of our portfolio managers.

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