Passive and Active Investments Explained

By Thomas Kidd

Investment options can carry a wide variety of assets, but how are those assets selected? Generally speaking, investment options fall into one of two management styles which we refer to as passive and active management. Understanding these two different management styles is an important part of selecting an investment option. Below is a brief explanation of each of these management styles and some of the potential advantages and disadvantages to each.

Defining Passive and Active investments

Passively managed funds aim to track a benchmark index, such as the S&P 500, by holding all or a representative sample of the securities in the index. The objective is to replicate the performance of the index with low management fees. For example, and index fund might hold all 500 stocks in the S&P 500 in the same proportion as the index. When the index changes (for example, if a company is added or removed from the index), the fund would similarly adjust its holdings to match the new composition of the index. The fund's performance should therefore closely track the performance of the index, minus any management fees and other expenses. This approach will work if the benchmark index grows in value over the long-term.

In contrast, actively managed funds are managed by investment professionals who make decisions on which securities to buy, hold, or sell. Through careful research, investment managers will try to identify trends in the market, as well as consider external factors, in order to predict which securities will perform best. Usually the performance of the fund is measured against a benchmark, which may be a market index such as the S&P 500, an absolute percentage, or other measures such as the Consumer Price Index, to demonstrate whether the fund is achieving its goals.

Pros and Cons

Each of these management styles can carry certain advantages and disadvantages. The advantage of a passively managed fund is that it is fairly low maintenance for the investment managers; they do not need to make investment decisions to try to increase returns, as they simply follow movements in the given index. As a result, passively managed funds tend to have lower management costs. However, where index funds tend to fall behind is during poor market conditions and periods of significant volatility. This is because while active fund managers will make investment decisions to try to combat volatility and avoid excessive losses, passive funds will go down with the index that they follow.

Actively managed funds generally have higher management fees as they require more resources and expertise to manage; they rely on extensive research to identify market trends and opportunities that may arise. This means they are able to respond to changing economic conditions, and potentially outperform their targets if they are successful.

In attempting to outperform the index, an actively managed fund may allocate more assets to smaller companies, and have a higher concentration of assets, which can cause a higher degree of volatility. While this is not always the case, it’s important to keep in mind that risk and return are intrinsically linked, so higher performance targets are going to come with more volatility.

Our Investment Philosophy

When it comes to selecting investments, we believe that both management styles can be suitable in different situations. It’s worth noting also that some investment options will use an approach that combines elements of both passive and active management, which will carry some of the advantages and disadvantages of each style. Our aim is to understand our clients’ circumstances and help them set clear financial goals so that we can select an investment option that best suits them.