Q Can you explain to me the difference between active management and passive management?
A There is much debate, within the investment and academic communities, over the merits of the two styles. With active management, there is a portfolio manager that is “actively” selecting and managing the holdings within the portfolio. For this management function they are charging a management fee.
Common examples of this style would be most mutual funds, separate account money managers, or a registered representative or registered investment adviser that selects and manages investments for your portfolio.
Passive investment, as the name implies, takes a less active role in the management of the holdings. The portfolio is designed to mimic an index or some other pre-determined strategy; (an index is a composite of securities that provides a performance benchmark. Indexes are unmanaged,
do not incur management fees, costs and expenses and cannot be invested in directly). Passive investment holdings are chosen and then periodically adjusted or rebalanced.
There is generally not a manager managing the portfolio. These types of portfolios typically have lower expenses and management fees than their active counterparts. Examples of passive investments would be exchange traded funds (ETFs), index mutual funds, and certain unit investment trusts (UITs).
Proponents of the active style will argue that a good manager can outperform the market and achieve higher returns than a market or index-based strategy.
Be careful that you are not looking “in the rear view mirror” when it comes to choosing a manager.
Don’t get caught up in chasing last year’s hot investments. Remember the market is the net result of all investors. If one asset outperforms the market, another asset has underperformed to “average” out. If you are going the active route, look for managers with successful long-term results and for firms that have a strong corporate structure and and ethics.
Proponents of passive investing will argue that it is hard to consistently outperform the market on an after-expenses basis. The active manager must achieve enough excess return to cover management expenses.
While there are many good money managers out there, research has shown that it is difficult to consistently outperform the market. With passive investing you are content to track the performance of the market or benchmarks.
There is no right or wrong answer for which style to use. A lot of it depends on your personality and the goals that you have for your investments. One strategy might be to include both types of styles into a portfolio. Many people utilize passive strategies for the “core” of their portfolios and active strategies for “satellite” holdings. Whatever strategy you choose, just remember that it is important to employ asset allocation and proper diversification in your portfolio. It is important to remember that asset allocation and diversification do not guarantee against market loss or ensure market gains. They are techniques to help manage investment risk.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Greg Epps is a registered representative and Certified Financial Planner with Epps Financial Partners. 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.