Investors have been debating the merits of “active” versus “passive” investing for a while now. We break down those concepts and explain why both strategies can have a role in your portfolio.
In my work at Morgan Stanley Wealth Management, I spend a lot of time thinking about how to construct investment portfolios—and these days, a big part of that conversation centers on the role of active and passive styles of investing, an ongoing (and sometimes quite heated!) debate in the financial industry.
This isn’t just an academic conversation: It has the potential to affect your investment results in a real and meaningful way.
Active investing means investing in funds whose portfolio managers select investments based on an independent assessment of each investment’s worth—essentially, trying to choose the most attractive investments. Generally speaking, the goal of active managers is to “beat the market,” or outperform certain standard benchmarks. For example, if you’re an active investor, your goal may be to achieve better returns than the S&P 500.
If you’re a passive investor, you wouldn’t undergo the process of assessing the virtue of any specific investment. Your goal would be to match the performance of certain market indexes rather than trying to outperform them. Passive managers simply seek to own all the stocks in a given market index, in the proportion they are held in that index. Because active investing is generally more expensive (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), many active managers fail to beat the index after accounting for expenses—in those cases, passive investing has typically outperformed because of its lower fees.
That depends who you ask. While passive investing has grown in popularity over the last few years, Morgan Stanley Wealth Management has found that in many cases active management may help investors improve their risk-adjusted returns. We’ve found that active managers can be especially helpful during periods of market stress, when outperformance can be most critical for investors.
Active strategies have tended to benefit investors more in certain investing climates, and passive strategies have tended to outperform in others. Generally, when the market is volatile, active managers may outperform more often than when it is not. When specific securities within the market are highly correlated or moving in unison, passive strategies may be the better way to go. Investors may be able to benefit from mixing both passive and active strategies—the best of both worlds, if you will—in a way that leverages the most valuable attributes of each. Market conditions change all the time, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments.
If pursuing a “best of both worlds” approach, it is also worth noting that achieving successful active management has historically proven more difficult within select asset classes and portions of the market, such as among the stocks of large U.S. companies. As a result, it may make sense, if appropriate for your situation, to veer a bit more passive in those areas and rely more on active investing in asset classes and parts of the market where it has historically proven more profitable to do so, such as among international stocks and those of smaller U.S. companies.
Some investors have very strong opinions about this topic and may not be persuaded by our nuanced view that both approaches may have a place in investors’ portfolios. If your top priority as an investor is to reduce your fees and trading costs, period, an all-passive portfolio might make sense for you. In our experience, investors tend to care more about factors like risk, return and liquidity than they do fees, so we believe that a mixed approach may be beneficial for all investors—conservative and aggressive alike.
As with many choices investors face, it really comes down to your personal priorities, timelines and goals.