Estimated reading time: 4 minutes
One of the key decisions you have to make when creating an investment strategy is whether you will be using an active or passive based investment management style. The key difference between these two styles comes down to how the investments are chosen and the level of work required (and hence the fees to be paid for the management of your assets).
Active management:
Active management is the management of your investment with a fund manager that makes ‘active’ decisions on what the underlying investments will be. An active manager typically has a benchmark to beat, or some other measure of performance as their goal of investing. The fund manager will choose certain securities to attempt to receive higher returns than average. Due to the fund manager requiring significant research and resources to attempt to outperform, this typically introduces a significantly higher cost compared to a passive investment.
Passive management
Passive management is a type of investment management style that is ‘passive’ in their decisions on what the underlying investments are. A passive fund will have a benchmark that they aim to replicate through either purchasing or otherwise gaining exposure to the underlying securities. As you are not paying for a fund manager to research investments, passive funds are typically very low cost, depending on what benchmark you are replicating.
What’s the difference?
Depending on your investment strategy and philosophy, both management styles may play a role in your investment portfolio. Passive funds typically outperform most active managers over the long term depending on the benchmark. Large and well researched benchmarks such as US stocks are harder to outperform with active management, whilst less researched and smaller benchmarks have a higher chance of outperforming with active management.
Morningstar in 2022 found that over the 12 months to June 2022 approximately 40% of US actively managed funds outperformed their passive peers. However, the longer the time frame the lower the chance of outperforming. When Morningstar compared the prior decade to June 2022, they found it was only approximately 25% of active funds could outperform.
Why would I consider Active management if it underperforms?
There is still some valid reasoning to include active management in portfolios for the long term. The most obvious is if you do find an active manager that can outperform, you can be significantly better off. However, this tends to be more about luck than skill in picking a strong manager.
Other reasons to consider active management is that in certain markets and asset classes, there is higher chances for an active manager to outperform. Markets that are illiquid, not transparent, small in size or otherwise inefficient can reward active managers compared to passive managers.
In addition, some managers do not try to merely replicate a benchmark, they may provide other benefits such as lower volatility or enhanced strategies not available to passive managers. This can provide a valuable component of your portfolio to maximise the probability of you meeting your financial goals.
Author: Harrison Trippett
Disclosures:
- Past performance is not a reliable indicator of future performance.
- This information has been compiled from sources considered to be reliable, but is not guaranteed.
