Personal Finance: Passive, active investing each possess strengths

One of the longest-standing debates in investing is over the relative merits of active portfolio management versus passive management. With an actively managed portfolio, a manager tries to beat the performance of a given benchmark index by using his judgment in selecting individual securities and deciding when to buy and sell them. A passively managed portfolio attempts to match that benchmark performance, and in the process, minimize expenses that can reduce an investor's net return.

Each camp has strong advocates who argue that the advantages of its approach outweigh those for the opposite side.

Active investing: attempting to add value

Proponents of active management believe that by picking the right investments, taking advantage of market trends, and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index. For example, an active

manager whose benchmark is the Standard & Poor's 500 Index might attempt to earn better-than-market returns by overweighting certain industries or individual securities, allocating more to those sectors than the index does.

Or a manager might try to control a portfolio's overall risk by temporarily increasing the percentage devoted to more conservative investments, such as cash alternatives.

An actively managed individual portfolio also permits its manager to take tax considerations into account. For example, a separately managed account can harvest capital losses to offset any capital gains realized by its owner, or time a sale to minimize any capital gains. An actively managed mutual fund can do the same on behalf of its collective shareholders.

However, an actively managed mutual fund's investment objective will put some limits on its manager's flexibility; for example, a fund may be required to maintain a certain percentage of its assets in a particular type of security. A fund's prospectus will outline any such provisions, and you should read it before investing.

Passive investing: focusing on costs

Advocates of unmanaged, passive investing - sometimes referred to as indexing - have long argued that the best way to capture overall market returns is to use low-cost market-tracking index investments.

This approach is based on the concept of the efficient market, which states that because all investors have access to all the necessary information about a company and its securities, it's difficult, if not impossible to gain an advantage over any other investor.

As new information becomes available, market prices adjust in response to reflect a security's true value. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.

Indexing creates certain cost efficiencies. Because the investment simply reflects an index, no research is required for securities selection. Also, because trading is relatively infrequent - passively managed portfolios typically buy or sell securities only when the index itself changes - trading costs often are lower. Also, infrequent trading typically generates fewer capital gains distributions, which means relative tax efficiency.

Popular investment choices that use passive management are index funds and exchange-traded funds.

However, some actively managed ETFs are now being introduced, and index funds and ETFs can be used as part of an active manager's strategy.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital - demosscapital.com. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com

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